Synchronicity and Fragility

Abstract

We show that the correlation across financial institutions is a major force that increases their overall fragility. Our model features a financial system with banks individually prone to runs and interconnected through fire sales. Strategic complementarities within and across banks amplify each other, and this causes the correlation in their risks to be a key factor driving the fragility of each bank and the system as a whole. Reducing asset commonality and improving bank-specific disclosure alleviate fragility through desynchronizing runs across banks. Secondary market liquidity injections have a significant stabilizing effect through synchronicity reduction on top of their direct effect.

JEL Classification: G01, G21, G28