Complexity and Financial Panics
Ricardo J. Caballero
Massachusetts Institute of Technology (MIT) - Department of Economics; National Bureau of Economic Research (NBER)
Harvard University - Department of Economics; National Bureau of Economic Research (NBER)
June 17, 2009
MIT Department of Economics Working Paper No. 09-17
During extreme financial crises, all of a sudden, the financial world that was once rife with profit opportunities for financial institutions (banks, for short), becomes exceedingly complex. Confusion and uncertainty follow, ravaging financial markets and triggering massive flight-to-quality episodes. In this paper we propose a model of this phenomenon. In our model, banks normally collect information about their trading partners which assures them of the soundness of these relationships. However, when acute financial distress emerges in parts of the financial network, it is not enough to be informed about these partners, as it also becomes important to learn about the health of their trading partners. As conditions continue to deteriorate, banks must learn about the health of the trading partners of the trading partners of the trading partners, and so on. At some point, the cost of information gathering becomes too unmanageable for banks, uncertainty spikes, and they have no option but to withdraw from loan commitments and illiquid positions. A flight-to-quality ensues, and the financial crisis spreads.
Number of Pages in PDF File: 37
Keywords: Financial network, complexity, uncertainty, flight to quality, cascades,crises, information cost, financial panic, credit crunch
JEL Classification: E0, G1, D8, E5working papers series
Date posted: June 5, 2009 ; Last revised: June 29, 2009
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