Complexity and Financial Panics

37 Pages Posted: 5 Jun 2009 Last revised: 13 Dec 2016

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)

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Date Written: June 17, 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.

Keywords: Financial network, complexity, uncertainty, flight to quality, cascades,crises, information cost, financial panic, credit crunch

JEL Classification: E0, G1, D8, E5

Suggested Citation

Caballero, Ricardo J. and Simsek, Alp, Complexity and Financial Panics (June 17, 2009). MIT Department of Economics Working Paper No. 09-17, Available at SSRN: https://ssrn.com/abstract=1414382 or http://dx.doi.org/10.2139/ssrn.1414382

Ricardo J. Caballero (Contact Author)

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Alp Simsek

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