Asset commonality, debt maturity and systemic risk

Allen, Franklin, Ana Babus, and Elena Carletti, 2012, “Asset commonality, debt maturity and systemic risk,” Journal of Financial Economics 104 (2012), 519-534.

Purpose:  To model a connection between the commonality of financial institutions’ (banks’) asset portfolios and the maturity of their debts.

Motivation:  The financial crisis starting in 2007 brought attention to the systemic risks stemming from linkages between the portfolios of financial institutions.  This paper investigates how debt maturity might cause such linkages to become a systemic risk.

Findings:

  • Long-term debt is not related to the riskiness of overlaps between institutions’ asset portfolios.
  • Clustered asset structures (where portfolios only overlap within a cluster) produce more systemic risk, and usually lead to lower total welfare.
  • Short-term debt can transfer insolvency between banks.
  • The use of short-term debt and the link between short-term debt and systemic risk, depend upon the structure of overlaps between banks’ portfolios (asset structure).

Model:  Six banks invest in six risky projects, exchange shares in their own project with others, and finance their investment with either short- or long-term debt in period 0.

  • The six banks exchange shares in each other’s projects to reduce risk, and do so in two patterns.
    • “Clustered” – two groups of three banks each exchange assets solely within the group, so that all banks within each group have identical portfolios.
      • In this structure, there is greater information spillover within groups, so trouble at one bank is most likely to also cause investors in the others not to roll over. Thus, there are more liquidations than in the unclustered group.
    • “Unclustered” – each bank exchanges only with the two neighboring banks, and no two banks have identical portfolios.
  • When banks use short-term debt, investors decide at the end of period 1 whether to roll over the banks’ debt based on a signal indicating whether at least one bank will fail.
  • Solvency or insolvency is determined at the end of period 2.
  • Investors’ failure to roll over causes early bank liquidation and is the source of systemic failure.

Conclusions:

  • When banks use short-term debt and have overlapping asset portfolios, the structure of the overlap is an important factor in determining systemic risk.