Financial Connections and Systemic Risk
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.
|Date of creation:||2010|
|Date of revision:|
|Contact details of provider:|| Postal: |
Web page: http://www.eui.eu/ECO/
More information through EDIRC
References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Wagner, Wolf, 2010.
"Diversification at financial institutions and systemic crises,"
Journal of Financial Intermediation,
Elsevier, vol. 19(3), pages 373-386, July.
- Wagner, W.B., 2006. "Diversification at Financial Institutions and Systemic Crises," Discussion Paper 2006-71, Tilburg University, Center for Economic Research.
- Matthew O. Jackson & Asher Wolinsky, 1994.
"A Strategic Model of Social and Economic Networks,"
1098, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
- Richard J. Herring & Susan Wachter, 1999. "Real Estate Booms and Banking Busts: An International Perspective," Center for Financial Institutions Working Papers 99-27, Wharton School Center for Financial Institutions, University of Pennsylvania.
- Flannery, Mark J, 1986. " Asymmetric Information and Risky Debt Maturity Choice," Journal of Finance, American Finance Association, vol. 41(1), pages 19-37, March.
- 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.
- 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.
- Freixas, Xavier & Parigi, Bruno M & Rochet, Jean-Charles, 2000.
"Systemic Risk, Interbank Relations, and Liquidity Provision by the Central Bank,"
Journal of Money, Credit and Banking,
Blackwell Publishing, vol. 32(3), pages 611-38, August.
- 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, pages 611-640.
- Xavier Freixas & Bruno Parigi & Jean Charles Rochet, 1998. "Systemic risk, interbank relations and liquidity provision by the Central Bank," Economics Working Papers 440, Department of Economics and Business, Universitat Pompeu Fabra, revised Sep 1999.
- X. Freixas & B. Parigi & J-C. Rochet, 2000. "Systemic Risk, Interbank Relations and Liquidity Provision by theCentral Bank," DNB Staff Reports (discontinued) 47, Netherlands Central Bank.
- Freixas, Xavier & Parigi, Bruno & Rochet, Jean-Charles, 1999. "Systemic Risk, Interbank Relations and Liquidity Provision by the Central Bank," CEPR Discussion Papers 2325, C.E.P.R. Discussion Papers.
- 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.
- Douglas W. Diamond & Raghuram G. Rajan, 2001. "Liquidity Risk, Liquidity Creation, and Financial Fragility: A Theory of Banking," Journal of Political Economy, University of Chicago Press, vol. 109(2), pages 287-327, April.
- 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, issue Sep.
- Douglas W. Diamond & Raghuram G. Rajan, . "Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking," CRSP working papers 476, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
- repec:dgr:kubcen:200671 is not listed on IDEAS
- Boyson, Nicole M. & Stahel, Christof W. & Stulz, Rene, 2008.
"Hedge Fund Contagion and Liquidity,"
Working Paper Series
2008-8, Ohio State University, Charles A. Dice Center for Research in Financial Economics.
- repec:dgr:kubcen:2007100 is not listed on IDEAS
- 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.
- Diamond, Douglas W, 1991. "Debt Maturity Structure and Liquidity Risk," The Quarterly Journal of Economics, MIT Press, vol. 106(3), pages 709-37, August.
When requesting a correction, please mention this item's handle: RePEc:eui:euiwps:eco2010/26. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Rhoda Lane)
If references are entirely missing, you can add them using this form.