Financial Connections and Systemic Risk

F. Allen, A. Babus, E. Carletti

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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.
Original languageEnglish
Place of PublicationTilburg
PublisherEBC
Number of pages43
Volume2010-23S
Publication statusPublished - 2010

Publication series

NameEBC Discussion Paper
Volume2010-23S

Keywords

  • Financial networks
  • diversification
  • short term finance
  • rollover risk

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  • Cite this

    Allen, F., Babus, A., & Carletti, E. (2010). Financial Connections and Systemic Risk. (EBC Discussion Paper; Vol. 2010-23S). EBC.