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Financial Connections and Systemic Risk

Understanding the nature of systemic risk is key to understanding the occurrence and propagation of financial crises. The term usually refers to a situation where many (if not all) financial institutions fail as a result of a common shock or a contagion process. Herring and Wachter (2001) and Reinhart and Rogoff (2009) find evidence that a collapse of residential or commercial real estate values is the main cause for system wide failures of financial institutions during many financial crises.

Allen and Gale (2000), Freixas, Parigi and Rochet (2000) and numerous other subsequent papers (see Allen, Babus and Carletti, 2009, for a survey) analyze the risk of contagion where the failure of one financial institution leads to the default of other financial institutions through a domino effect. This type of systemic risk is often used by central banks as the justification for intervening and bailing out institutions that are “too big to fail”.

The recent developments in financial markets and the crisis that started in 2007 have highlighted the importance of another type of systemic risk related to the structure of connections among financial institutions and their funding maturity. The emergence of financial instruments in the form of credit default swaps and other credit derivative products, loan sales and collateralized loan obligations has improved the possibility for financial institutions to diversify risk. However, it has also led to more overlap and more similarities among their portfolios.

This has increased the probability that the failure of one institution is likely to coincide with the failure of other similar institutions. Combining this with a greater reliance on wholesale short term finance has increased rollover risk for financial institutions. When a bank is in difficulty, investors may fear that other banks with similar portfolios will also be in trouble and hence may refuse to reinvest their funds. Financial markets can dry up and push all banks into difficulties.

Financial Connections and Systemic Risk