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Fire Sales in a Model of Complexity

Author

Listed:
  • RICARDO J. CABALLERO
  • ALP SIMSEK

Abstract

We present a model of financial crises that stem from endogenous complexity. We conceptualize complexity as banks' uncertainty about the financial network of cross exposures. As conditions deteriorate, cross exposures generate the possibility of a domino effect of bankruptcies. As this happens, banks face an increasingly complex environment since they need to understand a greater fraction of the financial network to assess their own financial health. Complexity dramatically amplifies banks' perceived counterparty risk, and makes relatively healthy banks reluctant to buy risky assets. The model also features a novel complexity externality.

Suggested Citation

  • Ricardo J. Caballero & Alp Simsek, 2013. "Fire Sales in a Model of Complexity," Journal of Finance, American Finance Association, vol. 68(6), pages 2549-2587, December.
    • Handle: RePEc:bla:jfinan:v:68:y:2013:i:6:p:2549-2587
    DOI: 10.1111/jofi.12087
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    JEL classification:

    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • E0 - Macroeconomics and Monetary Economics - - General
    • E5 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit
    • G1 - Financial Economics - - General Financial Markets

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