NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Financial Connections and Systemic Risk

Franklin Allen, Ana Babus, Elena Carletti

NBER Working Paper No. 16177
Issued in July 2010
NBER Program(s):   CF

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.

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Published: Financial Connections and Systemic Risk, Franklin Allen, Ana Babus, Elena Carletti, in Market Institutions and Financial Market Risk (2012), Elsevier, Journal of Financial Economics

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