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Financial Connections and Systemic Risk

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  • Franklin Allen
  • Ana Babus
  • Elena Carletti

Abstract

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.

Suggested Citation

  • Franklin Allen & Ana Babus & Elena Carletti, 2010. "Financial Connections and Systemic Risk," Economics Working Papers ECO2010/26, European University Institute.
  • Handle: RePEc:eui:euiwps:eco2010/26
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    References listed on IDEAS

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    More about this item

    JEL classification:

    • G01 - Financial Economics - - General - - - Financial Crises
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G2 - Financial Economics - - Financial Institutions and Services
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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