Financial Connections and Systemic Risk
University of Pennsylvania - Finance Department; European Corporate Governance Institute (ECGI)
Federal Reserve Bank of Chicago; Imperial College London
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
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
Date posted: August 28, 2010
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