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Financial Connections and Systemic Risk

European Banking Center Discussion Paper No. 2010-23S

CentER Discussion Paper Series No. 2010-88S

43 Pages Posted: 28 Aug 2010  

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: July 10, 2010

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.

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

JEL Classification: G01, G21

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: https://ssrn.com/abstract=1666109 or http://dx.doi.org/10.2139/ssrn.1666109

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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