Working Paper: NBER ID: w16177
Authors: Franklin Allen; Ana Babus; Elena Carletti
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: systemic risk; financial connections; network structure; short-term finance; long-term finance
JEL Codes: G01; G11; G21
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| network structure (clustered vs. unclustered) (D85) | investors' rollover decisions (G11) |
| investors' rollover decisions (G11) | systemic risk (E44) |
| network structure (clustered vs. unclustered) (D85) | systemic risk (E44) |
| investors' expectations about bank solvency (G21) | investors' rollover decisions (G11) |
| maturity of debt (G32) | welfare outcomes (I38) |
| network structure (clustered vs. unclustered) (D85) | welfare outcomes (I38) |
| bad news about bank solvency (G21) | early liquidation (G33) |
| network structure (clustered vs. unclustered) (D85) | likelihood of early liquidation (G33) |