Financial Connections and Systemic Risk

F. Allen, A. Babus, E. Carletti

Research output: Working paperDiscussion paperOther research output

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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
PublisherFinance
Number of pages43
Volume2010-88S
Publication statusPublished - 2010

Publication series

NameCentER Discussion Paper
Volume2010-88S

Fingerprint

Systemic risk
Finance
Network structure
Investors
Rollover
Debt
Individual risk
Financial institutions
Solvency
Swaps

Keywords

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

Cite this

Allen, F., Babus, A., & Carletti, E. (2010). Financial Connections and Systemic Risk. (CentER Discussion Paper; Vol. 2010-88S). Tilburg: Finance.
Allen, F. ; Babus, A. ; Carletti, E. / Financial Connections and Systemic Risk. Tilburg : Finance, 2010. (CentER Discussion Paper).
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Allen, F, Babus, A & Carletti, E 2010 'Financial Connections and Systemic Risk' CentER Discussion Paper, vol. 2010-88S, Finance, Tilburg.

Financial Connections and Systemic Risk. / Allen, F.; Babus, A.; Carletti, E.

Tilburg : Finance, 2010. (CentER Discussion Paper; Vol. 2010-88S).

Research output: Working paperDiscussion paperOther research output

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N2 - 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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Allen F, Babus A, Carletti E. Financial Connections and Systemic Risk. Tilburg: Finance. 2010. (CentER Discussion Paper).