Financial Connections and Systemic Risk

Franklin Allen, Ana Babus and Elena Carletti ()

No ECO2010/26, Economics Working Papers from European University Institute

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.

Date: 2010
New Economics Papers: this item is included in nep-ban and nep-net
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Related works:
Working Paper: Financial Connections and Systemic Risk (2010)
Working Paper: Financial Connections and Systemic Risk (2010)
Working Paper: Financial Connections and Systemic Risk (2010)
Working Paper: Financial Connections and Systemic Risk (2010)
Working Paper: Financial Connections and Systemic Risk (2010)
Working Paper: Financial Connections and Systemic Risk (2010)
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