Systemic Risk-Shifting in Financial Networks
53 Pages Posted: 11 Sep 2015 Last revised: 20 Jul 2020
Date Written: May 30, 2020
Banks face different but potentially correlated risks from outside the financial system. Financial connections can share these risks, but also create the means by which shocks can propagate. We examine this tradeoff in the context of a new stylised fact we present: German banks are more likely to have financial connections when they face more similar risks---potentially undermining the risk sharing role of financial connections and contributing to systemic risk. We find that such patterns are socially suboptimal, but can be explained by risk-shifting. Risk-shifting motivates banks to correlate their failures with their counterparties, even though it creates systemic risk.
Keywords: Financial Networks, Systemic Risk, Risk-sharing, Limited Liability, Debtor Discipline, Homophily
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