Complexity and Financial Panics

37 Pages Posted: 26 May 2009 Last revised: 25 Dec 2022

See all articles by Ricardo J. Caballero

Ricardo J. Caballero

Massachusetts Institute of Technology (MIT) - Department of Economics; National Bureau of Economic Research (NBER)

Alp Simsek

Yale School of Management; National Bureau of Economic Research (NBER); Centre for Economic Policy Research (CEPR)

Multiple version iconThere are 2 versions of this paper

Date Written: May 2009

Abstract

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.

Suggested Citation

Caballero, Ricardo J. and Simsek, Alp, Complexity and Financial Panics (May 2009). NBER Working Paper No. w14997, Available at SSRN: https://ssrn.com/abstract=1408917

Ricardo J. Caballero (Contact Author)

Massachusetts Institute of Technology (MIT) - Department of Economics ( email )

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Alp Simsek

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Centre for Economic Policy Research (CEPR) ( email )

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