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Financial Connections and Systemic Risk

In: Market Institutions and Financial Market Risk

  • Franklin Allen
  • Ana Babus
  • Elena Carletti

An 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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This chapter was published in:
  • Mark Carey & Anil Kashyap & Raghuram Rajan & RenĂ© Stulz, 2012. "Market Institutions and Financial Market Risk," NBER Books, National Bureau of Economic Research, Inc, number care10-1, October.
  • This item is provided by National Bureau of Economic Research, Inc in its series NBER Chapters with number 13175.
    Handle: RePEc:nbr:nberch:13175
    Contact details of provider: Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.
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    1. 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.
    2. Wagner, W.B., 2006. "Diversification at Financial Institutions and Systemic Crises," Discussion Paper 2006-71, Tilburg University, Center for Economic Research.
    3. Douglas W Diamond, 2010. "Fear of fire sales and the credit freeze," BIS Working Papers 305, Bank for International Settlements.
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    8. Monica Billio & Mila Getmansky & Andrew W. Lo & Loriana Pelizzon, 2010. "Econometric Measures of Systemic Risk in the Finance and Insurance Sectors," NBER Chapters, in: Market Institutions and Financial Market Risk National Bureau of Economic Research, Inc.
    9. Castiglionesi, F. & Navarro, N., 2007. "Optimal Fragile Financial Networks," Discussion Paper 2007-100, Tilburg University, Center for Economic Research.
    10. Nicole M. Boyson & Christof W. Stahel & Rene M. Stulz, 2008. "Hedge Fund Contagion and Liquidity," NBER Working Papers 14068, National Bureau of Economic Research, Inc.
    11. Flannery, Mark J, 1986. " Asymmetric Information and Risky Debt Maturity Choice," Journal of Finance, American Finance Association, vol. 41(1), pages 19-37, March.
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    15. Diamond, Douglas W, 1991. "Debt Maturity Structure and Liquidity Risk," The Quarterly Journal of Economics, MIT Press, vol. 106(3), pages 709-37, August.
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