Asset Commonality, Debt Maturity and Systemic Risk

Abstract

We develop a model where financial institutions swap projects in order to diversify their individual risk. This can lead to two dfferent asset structures. In a clustered structure groups of financial institutions hold identical portfolios and default together. In an unclustered structure defaults are more dispersed. With long term finance welfare is the same in both structures. 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 all institutions are early liquidated. We compare investors’rollover decisions and welfare in the two asset structures.