#09-33
Financial Connections and Systemic Risk
Franklin Allen, Ana Babus and Elena Carletti, November 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.
Keywords: .
JEL classifications:
