Financial Connections and Systemic Risk
Posted: 4 Nov 2009
Date Written: November 3, 2009
We develop a model where financial institutions form strategic connections through overlapping portfolio exposures weighing the benefits of risk diversification against the costs of due-diligence. We study the effects of different network structures for systemic risk and welfare depending on whether financial institutions issue long or short term debt. Clustered networks where banks hold very similar portfolios are compared with unclustered networks where they hold less correlated portfolios. The network structure plays a role only in the case of short term financing, when investors condition their debt rollover decision on a signal revealing potential future bank defaults. We show that, depending on the size of costs banks incur when they default, the arrival of a negative signal can lead to early liquidation in a clustered network but not in an unclustered one so the latter can be superior. But if such a signal leads to early liquidation in both networks then the clustered network can be superior.
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