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Financial crises and the evaporation of trust

  • Kartik Anand
  • Prasanna Gai
  • Matteo Marsili

Trust lies at the crux of most economic transactions, with credit markets being a notable example. Drawing on insights from the literature on coordination games and network growth, we develop a simple model to clarify how trust breaks down in financial systems. We show how the arrival of bad news about a financial agent can lead others to lose confidence in it and how this, in turn, can spread across the entire system. Our results emphasize the role of hysteresis -- it takes considerable effort to regain trust once it has been broken. Although simple, the model provides a plausible account of the credit freeze that followed the global financial crisis of 2007/8, both in terms of the sequence of events and the measures taken (and being proposed) by the authorities.

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File URL: http://arxiv.org/pdf/0911.3099
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Paper provided by arXiv.org in its series Papers with number 0911.3099.

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Date of creation: Nov 2009
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Handle: RePEc:arx:papers:0911.3099
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  1. Ricardo J. Caballero & Alp Simsek, 2009. "Complexity and Financial Panics," NBER Working Papers 14997, National Bureau of Economic Research, Inc.
  2. Edward L. Glaeser & David I. Laibson & José A. Scheinkman & Christine L. Soutter, 2000. "Measuring Trust," The Quarterly Journal of Economics, MIT Press, vol. 115(3), pages 811-846, August.
    • Glaeser, Edward Ludwig & Laibson, David I. & Scheinkman, Jose A. & Soutter, Christine L., 2000. "Measuring Trust," Scholarly Articles 4481497, Harvard University Department of Economics.
  3. Viral V. Acharya & Douglas Gale & Tanju Yorulmazer, 2011. "Rollover Risk and Market Freezes," Journal of Finance, American Finance Association, vol. 66(4), pages 1177-1209, 08.
  4. Christian Upper, 2007. "Using counterfactual simulations to assess the danger of contagion in interbank markets," BIS Working Papers 234, Bank for International Settlements.
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