Elliott, M., Georg, C-P. and Hazell, J.
Systemic Risk Shifting in Financial Networks
Journal of Economic Theory
Vol. 191 no. 105157 (2021)
Abstract: Banks face different but potentially correlated risks from outside the financial system. Financial connections can share these risks, but they also create the means by which shocks can be propagated. We examine this tradeoff in the context of a new stylized fact we present: German banks are more likely to have financial connections when they face more similar risks. We develop a model that can rationalize such behavior. We argue that such patterns are socially suboptimal and raise systemic risk, but can be explained by risk shifting. Risk shifting motivates banks to correlate their failures with their counterparties, even though it creates systemic risk.
Keywords: Financial Networks, Asset Correlation, Contagion
JEL Codes: G21, G11, D85
Author links: Matthew Elliott
Publisher's Link: https://doi.org/10.1016/j.jet.2020.105157 