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A Model of Financial Fragility

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  • Lagunoff, Roger
  • Schreft, Stacey L.

Abstract

This paper presents a dynamic, stochastic game-theoretic model of financial fragility. The model has two essential features. First, interrelated portfolios and payment commitments forge financial linkages among agents. Second, iid shocks to investment projects’ operations at a single date cause some projects to fail. Investors who experience losses from project failures reallocate their portfolios, thereby breaking some linkages. In the Pareto-efficient symmetric equilibrium studied, two related types of financial crises can occur in response. One occurs gradually as defaults spread, causing even more links to break. An economy is more fragile ex post the more severe this financial crisis. The other type of crisis occurs instantaneously when forward-looking investors preemptively shift their wealth into a safe asset in anticipation of the contagion affecting them in the future. An economy is more fragile ex ante the earlier all of its linkages break from such a crisis. The paper also considers whether fragility is worse for larger economies.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of Economic Theory.

Volume (Year): 99 (2001)
Issue (Month): 1-2 (July)
Pages: 220-264

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Handle: RePEc:eee:jetheo:v:99:y:2001:i:1-2:p:220-264

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Web page: http://www.elsevier.com/locate/inca/622869

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  1. Andrew Atkeson & Jose-Victor Rios-Rull, 1995. "The Balance of Payments and Borrowing Constraints: An Alternative View of the Mexican Crisis," NBER Working Papers 5329, National Bureau of Economic Research, Inc.
  2. Harold L. Cole & Timothy J. Kehoe, 1998. "Self-Fulfilling Debt Crises," Levine's Working Paper Archive 114, David K. Levine.
  3. Banerjee, Abhijit V, 1992. "A Simple Model of Herd Behavior," The Quarterly Journal of Economics, MIT Press, vol. 107(3), pages 797-817, August.
  4. Krasa, Stefan & Villamil, Anne P, 1992. "A Theory of Optimal Bank Size," Oxford Economic Papers, Oxford University Press, vol. 44(4), pages 725-49, October.
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  6. Franklin Allen & Douglas Gale, 1998. "Optimal Financial Crises," Journal of Finance, American Finance Association, vol. 53(4), pages 1245-1284, 08.
  7. Cooper, R. & Corbae, D., 1997. "Financial Fragility and the Great Depression," Working Papers 97-08, University of Iowa, Department of Economics.
  8. Frederic S. Mishkin, 1990. "Asymmetric Information and Financial Crises: A Historical Perspective," NBER Working Papers 3400, National Bureau of Economic Research, Inc.
  9. Nobuhiro Kiyotaki & John Moore, 2004. "Credit Chains," ESE Discussion Papers 118, Edinburgh School of Economics, University of Edinburgh.
  10. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, vol. 51(3), pages 393-414, July.
  11. Hiroshi Fujiki & Edward J. Green & Akira Yamazaki, 1999. "Sharing the risk of settlement failure," Working Papers 594, Federal Reserve Bank of Minneapolis.
  12. Jean-Charles Rochet & Jean Tirole, 1996. "Interbank lending and systemic risk," Proceedings, Board of Governors of the Federal Reserve System (U.S.), pages 733-765.
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