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Financial Connections and Systemic Risk

Franklin Allen (), Ana Babus () and Elena Carletti ()

Working Papers from University of Pennsylvania, Wharton School, Weiss Center

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.

Date: 2010-07
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Working Paper: Financial Connections and Systemic Risk (2010) Downloads
Working Paper: Financial Connections and Systemic Risk (2010) Downloads
Working Paper: Financial Connections and Systemic Risk (2010) Downloads
Working Paper: Financial Connections and Systemic Risk (2010) Downloads
Working Paper: Financial Connections and Systemic Risk (2010) Downloads
Working Paper: Financial Connections and Systemic Risk (2010) Downloads
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