Financial Connections and Systemic Risk
AbstractAn important source of systemic risk is overlapping portfolio exposures among financial institutions. We develop a model where institutions form connections through swaps of projects in order to diversify their individual risk. These connections lead to two different network structures. In a clustered network groups of financial institutions within a cluster hold identical portfolios. Defaults occur together but the number of states where this happens is small. In an unclustered network defaults are more dispersed but they occur in more states. With long term finance there is no difference between the two structures in terms of total defaults and welfare. 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 the ability of financial institutions to repay them. If their updated expectations are low, they do not to roll over the debt and there is systemic risk in that all institutions are early liquidated. We compare the clustered and unclustered networks and analyze which is better in welfare terms.
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Bibliographic InfoPaper provided by European University Institute in its series Economics Working Papers with number ECO2010/26.
Date of creation: 2010
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Other versions of this item:
- Allen, Franklin & Babus, Ana & Carletti, Elena, 2010. "Financial Connections and Systemic Risk," Working Papers 10-20, University of Pennsylvania, Wharton School, Weiss Center.
- Franklin Allen & Ana Babus & Elena Carletti, 2010. "Financial Connections and Systemic Risk," Economics Working Papers ECO2010/30, European University Institute.
- Allen, F. & Babus, A. & Carletti, E., 2010. "Financial Connections and Systemic Risk," Discussion Paper 2010-88S, Tilburg University, Center for Economic Research.
- Franklin Allen & Ana Babus & Elena Carletti, 2010. "Financial Connections and Systemic Risk," NBER Working Papers 16177, National Bureau of Economic Research, Inc.
- G01 - Financial Economics - - General - - - Financial Crises
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
This paper has been announced in the following NEP Reports:
- NEP-ALL-2010-06-04 (All new papers)
- NEP-BAN-2010-06-04 (Banking)
- NEP-NET-2010-06-04 (Network Economics)
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