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Asset Commonality, Debt Maturity and Systemic Risk

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  • Allen, Franklin

    (University of PA)

  • Babus, Ana

    (Princeton University)

  • Carletti, Elena

    (European University Institute)

Abstract

We develop a model where financial institutions swap projects in order to diversify their individual risk. This can lead to two different asset structures. In a clustered structure groups of financial institutions hold identical portfolios and default together. In an unclustered structure defaults are more dispersed. With long term finance welfare is the same in both structures. In contrast, when short term finance is used, the network structure matters. Upon the arrival of a signal about banks' future defaults, investors update their expectations of bank solvency. If their expectations are low, they do not roll over the debt and all institutions are early liquidated. We compare investors' rollover decisions and welfare in the two asset structures.

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Bibliographic Info

Paper provided by University of Pennsylvania, Wharton School, Weiss Center in its series Working Papers with number 10-30.

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Date of creation: Feb 2013
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Handle: RePEc:ecl:upafin:10-30

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  1. Allen, Franklin & Babus, Ana & Carletti, Elena, 2012. "Asset commonality, debt maturity and systemic risk," Journal of Financial Economics, Elsevier, vol. 104(3), pages 519-534.
  2. Castiglionesi, F. & Navarro, N., 2007. "Optimal Fragile Financial Networks," Discussion Paper 2007-100, Tilburg University, Center for Economic Research.
  3. Patrick Bolton & Tano Santos & Jose A. Scheinkman, 2009. "Outside and Inside Liquidity," NBER Working Papers 14867, National Bureau of Economic Research, Inc.
  4. Ibragimov, Rustam & Jaffee, Dwight & Walden, Johan, 2011. "Diversification disasters," Journal of Financial Economics, Elsevier, vol. 99(2), pages 333-348, February.
  5. Douglas W. Diamond & Raghuram G. Rajan, 1999. "Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking," NBER Working Papers 7430, National Bureau of Economic Research, Inc.
  6. Matthew O. Jackson & Asher Wolinsky, 1995. "A Strategic Model of Social and Economic Networks," Discussion Papers 1098R, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  7. Yehning Chen, 1999. "Banking Panics: The Role of the First-Come, First-Served Rule and Information Externalities," Journal of Political Economy, University of Chicago Press, vol. 107(5), pages 946-968, October.
  8. Bizer, David S & DeMarzo, Peter M, 1992. "Sequential Banking," Journal of Political Economy, University of Chicago Press, vol. 100(1), pages 41-61, February.
  9. Acharya, Viral V. & Gale, Douglas M & Yorulmazer, Tanju, 2009. "Rollover Risk and Market Freezes," CEPR Discussion Papers 7122, C.E.P.R. Discussion Papers.
  10. Ana Babus, 2007. "The Formation of Financial Networks," Working Papers 2007.69, Fondazione Eni Enrico Mattei.
  11. Calomiris, Charles W & Kahn, Charles M, 1991. "The Role of Demandable Debt in Structuring Optimal Banking Arrangements," American Economic Review, American Economic Association, vol. 81(3), pages 497-513, June.
  12. Wagner, W.B., 2006. "Diversification at Financial Institutions and Systemic Crises," Discussion Paper 2006-71, Tilburg University, Center for Economic Research.
  13. Viral V. Acharya & Tanju Yorulmazer, 2008. "Information Contagion and Bank Herding," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 40(1), pages 215-231, 02.
  14. Alberto Bisin & Piero Gottardi, 2006. "Efficient Competitive Equilibria with Adverse Selection," Journal of Political Economy, University of Chicago Press, vol. 114(3), pages 485-516, June.
  15. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "This Time Is Different: Eight Centuries of Financial Folly," Economics Books, Princeton University Press, edition 1, volume 1, number 8973.
  16. Flannery, Mark J, 1986. " Asymmetric Information and Risky Debt Maturity Choice," Journal of Finance, American Finance Association, vol. 41(1), pages 19-37, March.
  17. Amil Dasgupta, 2004. "Financial Contagion Through Capital Connections: A Model of the Origin and Spread of Bank Panics," Journal of the European Economic Association, MIT Press, vol. 2(6), pages 1049-1084, December.
  18. Diamond, Douglas W, 1991. "Debt Maturity Structure and Liquidity Risk," The Quarterly Journal of Economics, MIT Press, vol. 106(3), pages 709-37, August.
  19. Franklin Allen & Ana Babus & Elena Carletti, 2009. "Financial Crises: Theory and Evidence," Annual Review of Financial Economics, Annual Reviews, vol. 1(1), pages 97-116, November.
  20. Douglas W. Diamond & Raghuram G. Rajan, 2011. "Fear of Fire Sales, Illiquidity Seeking, and Credit Freezes," The Quarterly Journal of Economics, Oxford University Press, vol. 126(2), pages 557-591.
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