Complex Financial Institutions and Systemic Risk
61 Pages Posted: 15 Apr 2011 Last revised: 21 Jan 2014
This Article takes a novel approach to the “too-big-to-fail” problem. It begins by asking a foundational question: given the extraordinary volume of transactions between complex financial institutions, what mechanisms do these institutions use to deal with the transactional risks created by their mutual complexity? I explore two general approaches available to them. A party can acquire information to pierce through the complexity - an information-intensive strategy. But since information costs increase with complexity, at some point the costs will be so great that a party will enter into the transaction only if it can transact “blindly”. A blind strategy is one in which one party treats the other as a “black box” and protects itself by using other types of contractual mechanisms. I develop a theory of “blind-debt” contracting and show that a debtholder can transact blindly by taking sufficient collateral and making maturities infinitesimally small. In the period leading to the recent crisis, financial institutions increasingly turned to overnight repos - which are essentially, collateralized overnight debt - to finance their operations. As the maturity of repos became increasingly short they began to resemble a second type of blind debt - demand deposits. As institutions became increasingly dependent of blind debt they open themselves to the same type or “runs” to which demand deposit accounts are susceptible. I then develop various legal implications, particularly with regard to the Dodd-Frank Act.
Keywords: financial and banking regulation, financial institutions, Dodd-Frank, repos, short-term debt, derivatives, contagion, bank run, systemic risk, leverage, liquidity, risk management, monitoring, transparency, complexity, too-big-to-fail, intermediation, coordination failures, herding
JEL Classification: G21, G28, G32, K22, K23
Suggested Citation: Suggested Citation