Financial Networks over the Business Cycle

Abstract

I present a dynamic general equilibrium model in which financial interconnectedness endogenously changes over the business cycle and shapes systemic risk. To share individual risks, banks become interconnected through holding overlapping asset portfolios. Diversification reduces individual banks' default probabilities but increases the similarity of their exposures to fundamental shocks. Systemic financial crises burst at the end of credit booms when productive investment opportunities are exhausted, banks' balance sheets are weak, and their portfolios are strongly correlated. Under such circumstances, financial fragility is magnified, and even a moderate negative shock can lead to simultaneous defaults of many interconnected banks.