Financial Connections and Systemic Risk

Posted: 4 Nov 2009

See all articles by Franklin Allen

Franklin Allen

Imperial College London

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)

Multiple version iconThere are 3 versions of this paper

Date Written: November 3, 2009

Abstract

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.

Suggested Citation

Allen, Franklin and Babus, Ana and Carletti, Elena, Financial Connections and Systemic Risk (November 3, 2009). Available at SSRN: https://ssrn.com/abstract=1499407

Franklin Allen (Contact Author)

Imperial College London ( email )

South Kensington Campus
Exhibition Road
London, Greater London SW7 2AZ
United Kingdom

Ana Babus

Federal Reserve Bank of Chicago ( email )

230 South LaSalle Street
Chicago, IL 60604
United States

Imperial College London ( email )

South Kensington Campus
Exhibition Road
London, Greater 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 )

Villa La Fonte, via delle Fontanelle 18
50016 San Domenico di Fiesole
Florence, Florence 50014
Italy

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