Understanding the nature of systemic risk is key to understanding the occurrence and propagation of financial crises. Traditionally the term "systemic risk" describes a situation where many (if not all) financial institutions fail as a result of a common shock or a contagion process. A typical common shock leading to systemic failures is a collapse of residential or commercial real estate values (see Reinhart and Rogoff, 2009). Contagion refers to the risk that the failure of one financial institution leads to the default of others through a domino e¤ect in the interbank market, the payment system or though asset prices (see, for example, the survey in Allen, Babus and Carletti, 2009).
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 linkages among financial institutions and to their funding maturity. The emergence of financial instruments in the form of credit default swaps and similar products has improved the possibility for financial institutions to diversify risk, but it has also increased the overlaps in their portfolios. Whether and how such asset commonality among banks leads to systemic risk may depend on their funding maturity structure. With short-term debt, banks are informationally linked. Investors respond to the arrival of interim information in a way that depends on the composition of their asset structures. With long-term debt instead, interim information plays no role and the composition of asset structures does not matter for systemic risk.
In this paper we analyze the interaction between asset commonality and funding maturity in generating systemic risk through an informational channel. We develop a simple two-period model, where each bank issues debt to finance a risky project. We initially consider the case of long-term debt and then that of short-term debt. Projects are risky and thus banks may default at the final date. Bankruptcy is costly in that investors only recover a fraction of the banks project return.
As project returns are independently distributed, banks have an incentive to diversify to lower their individual default proba-bility. We model this by assuming that each bank can exchange shares of its own project with other banks. Exchanging projects is costly as it entails a due diligence cost for each swapped project. In equilibrium, banks trade off the advantages of diversi?cation in terms of lower default probability with the due diligence costs.
