Diversification and Endogenous Financial Networks

TL;DR

This paper investigates how diversification motives can explain the endogenous formation of financial networks among heterogeneous institutions, highlighting regulatory impacts and providing both theoretical and simulation insights.

Contribution

It introduces a model explaining financial interconnections through diversification motives and analyzes regulatory effects on these networks.

Findings

Diversification motive plausibly explains interconnections among key financial institutions.

Regulatory constraints significantly influence the structure of financial networks.

The model aligns with empirical observations of long-term exposures.

Abstract

We test the hypothesis that interconnections across financial institutions can be explained by a diversification motive. This idea stems from the empirical evidence of the existence of long-term exposures that cannot be explained by a liquidity motive (maturity or currency mismatch). We model endogenous interconnections of heterogenous financial institutions facing regulatory constraints using a maximization of their expected utility. Both theoretical and simulation-based results are compared to a stylized genuine financial network. The diversification motive appears to plausibly explain interconnections among key players. Using our model, the impact of regulation on interconnections between banks -currently discussed at the Basel Committee on Banking Supervision- is analyzed.