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Financial Connections and Systemic Risk

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  • Franklin Allen
  • Ana Babus
  • Elena Carletti

Abstract

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 hold identical portfolios and default together. In an unclustered network defaults are more dispersed. With long term finance welfare is the same in both networks. 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 there is systemic risk in that all institutions are early liquidated. We compare investors' rollover decisions and welfare in the two networks.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 16177.

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Date of creation: Jul 2010
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Publication status: published as Financial Connections and Systemic Risk , Franklin Allen, Ana Babus, Elena Carletti. in Market Institutions and Financial Market Risk , Carey, Kashyap, Rajan, and Stulz. 2012
Handle: RePEc:nbr:nberwo:16177

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  1. Wagner, W.B., 2006. "Diversification at Financial Institutions and Systemic Crises," Discussion Paper, Tilburg University, Center for Economic Research 2006-71, Tilburg University, Center for Economic Research.
  2. Calomiris, Charles W & Kahn, Charles M, 1991. "The Role of Demandable Debt in Structuring Optimal Banking Arrangements," American Economic Review, American Economic Association, American Economic Association, vol. 81(3), pages 497-513, June.
  3. Douglas W. Diamond & Raghuram G. Rajan, 1998. "Liquidity risk, liquidity creation and financial fragility: a theory of banking," Proceedings, Federal Reserve Bank of San Francisco, Federal Reserve Bank of San Francisco, issue Sep.
  4. Matthew O. Jackson & Asher Wolinsky, 1995. "A Strategic Model of Social and Economic Networks," Discussion Papers, Northwestern University, Center for Mathematical Studies in Economics and Management Science 1098R, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  5. Boyson, Nicole M. & Stahel, Christof W. & Stulz, Rene, 2008. "Hedge Fund Contagion and Liquidity," Working Paper Series, Ohio State University, Charles A. Dice Center for Research in Financial Economics 2008-8, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
  6. Franklin Allen & Ana Babus & Elena Carletti, 2009. "Financial Crises: Theory and Evidence," Annual Review of Financial Economics, Annual Reviews, Annual Reviews, vol. 1(1), pages 97-116, November.
  7. Xavier Freixas & Bruno M. Parigi & Jean-Charles Rochet, 2000. "Systemic risk, interbank relations, and liquidity provision by the central bank," Proceedings, Federal Reserve Bank of Cleveland, Federal Reserve Bank of Cleveland, pages 611-640.
  8. Richard J. Herring & Susan Wachter, 1999. "Real Estate Booms and Banking Busts: An International Perspective," Center for Financial Institutions Working Papers, Wharton School Center for Financial Institutions, University of Pennsylvania 99-27, Wharton School Center for Financial Institutions, University of Pennsylvania.
  9. Carmen M. Reinhart & Kenneth S. Rogoff, 2009. "This Time Is Different: Eight Centuries of Financial Folly," Economics Books, Princeton University Press, Princeton University Press, edition 1, volume 1, number 8973.
  10. Flannery, Mark J, 1986. " Asymmetric Information and Risky Debt Maturity Choice," Journal of Finance, American Finance Association, American Finance Association, vol. 41(1), pages 19-37, March.
  11. Diamond, Douglas W, 1991. "Debt Maturity Structure and Liquidity Risk," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 106(3), pages 709-37, August.
  12. Castiglionesi, F. & Navarro, N., 2007. "Optimal Fragile Financial Networks," Discussion Paper, Tilburg University, Center for Economic Research 2007-100, Tilburg University, Center for Economic Research.
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