Abstract

http://ssrn.com/abstract=1666109
 
 

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Financial Connections and Systemic Risk


Franklin Allen


University of Pennsylvania - Finance Department; European Corporate Governance Institute (ECGI)

Ana Babus


Federal Reserve Bank of Chicago; Imperial College London

Elena Carletti


Bocconi University - Department of Finance; European University Institute - Robert Schuman Centre for Advanced Studies (RSCAS)

July 10, 2010

European Banking Center Discussion Paper No. 2010-23S
CentER Discussion Paper Series No. 2010-88S

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.

Number of Pages in PDF File: 43

Keywords: Financial networks, diversification, short term finance, rollover risk

JEL Classification: G01, G21

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Date posted: August 28, 2010  

Suggested Citation

Allen, Franklin and Babus, Ana and Carletti, Elena, Financial Connections and Systemic Risk (July 10, 2010). European Banking Center Discussion Paper No. 2010-23S. Available at SSRN: http://ssrn.com/abstract=1666109 or http://dx.doi.org/10.2139/ssrn.1666109

Contact Information

Franklin Allen (Contact Author)
University of Pennsylvania - Finance Department ( email )
The Wharton School
3620 Locust Walk
Philadelphia, PA 19104
United States
215-898-3629 (Phone)
215-573-2207 (Fax)
HOME PAGE: http://finance.wharton.upenn.edu/~allenf/

European Corporate Governance Institute (ECGI)
c/o ECARES ULB CP 114
B-1050 Brussels
Belgium
HOME PAGE: http://www.ecgi.org
Ana Babus
Federal Reserve Bank of Chicago ( email )
230 South LaSalle Street
Chicago, IL 60604
United States
Imperial College London ( email )
South Kensington Campus
London SW7 2AZ
United Kingdom
HOME PAGE: http://www.anababus.net
Elena Carletti
Bocconi University - Department of Finance ( email )
Via Roentgen 1
Milano, MI 20136
Italy
European University Institute - Robert Schuman Centre for Advanced Studies (RSCAS) ( email )
Via dei Roccettini 9
via delle Fontanelle 10
50016 San Domenico di Fiesole, Florence 50014
Italy
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