Complexity and Financial Panics
During extreme financial crises, all of a sudden, the financial world that was once rife with profit opportunities for financial institutions (banks, for short) becomes exceedingly complex. Confusion and uncertainty follow, ravaging financial markets and triggering massive flight-to-quality episodes. In this paper we propose a model of this phenomenon. In our model, banks normally collect information about their trading partners which assures them of the soundness of these relationships. However, when acute financial distress emerges in parts of the financial network, it is not enough to be informed about these partners, as it also becomes important to learn about the health of their trading partners. As conditions continue to deteriorate, banks must learn about the health of the trading partners of the trading partners of the trading partners, and so on. At some point, the cost of information gathering becomes too unmanageable for banks, uncertainty spikes, and they have no option but to withdraw from loan commitments and illiquid positions. A flight-to-quality ensues, and the financial crisis spreads.
|Date of creation:||May 2009|
|Note:||AP CF EFG IFM|
|Contact details of provider:|| Postal: National Bureau of Economic Research, 1050 Massachusetts Avenue Cambridge, MA 02138, U.S.A.|
Web page: http://www.nber.org
More information through EDIRC
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Jean-Charles Rochet & Jean Tirole, 1996.
"Interbank lending and systemic risk,"
Board of Governors of the Federal Reserve System (U.S.), pages 733-765.
- Bryan Routledge & Stanley Zin, 2009.
"Model Uncertainty and Liquidity,"
Review of Economic Dynamics,
Elsevier for the Society for Economic Dynamics, vol. 12(4), pages 543-566, October.
- Bryan R. Routledge & Stanley E. Zin, 2000. "Model Uncertainty and Liquidity," Econometric Society World Congress 2000 Contributed Papers 1617, Econometric Society.
- Bryan R. Routledge, Stanley E. Zin, 2000. "Model Uncertainity And Liquidity," Computing in Economics and Finance 2000 368, Society for Computational Economics.
- Bryan Routledge & Stanley Zin, "undated". "Model Uncertainty and Liquidity," GSIA Working Papers 2001-E17, Carnegie Mellon University, Tepper School of Business.
- Bryan Routledge & Stanley Zin, 2009. "Code files for "Model Uncertainty and Liquidity"," Computer Codes 08-143, Review of Economic Dynamics.
- Bryan R. Routledge & Stanley E. Zin, 2001. "Model Uncertainty and Liquidity," NBER Working Papers 8683, National Bureau of Economic Research, Inc.
- Ricardo J. Caballero & Arvind Krishnamurthy, 2008.
"Collective Risk Management in a Flight to Quality Episode,"
Journal of Finance,
American Finance Association, vol. 63(5), pages 2195-2230, October.
- Ricardo J. Caballero & Arvind Krishnamurthy, 2007. "Collective Risk Management in a Flight to Quality Episode," NBER Working Papers 12896, National Bureau of Economic Research, Inc.
- X. Freixas & B. Parigi & J-C. Rochet, 2000.
"Systemic Risk, Interbank Relations and Liquidity Provision by theCentral Bank,"
DNB Staff Reports (discontinued)
47, Netherlands Central Bank.
- Freixas, Xavier & Parigi, Bruno M & Rochet, Jean-Charles, 2000. "Systemic Risk, Interbank Relations, and Liquidity Provision by the Central Bank," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 32(3), pages 611-638, August.
- Xavier Freixas & Bruno Parigi & Jean-Charles Rochet, 2000. "Systemic risk, interbank relations, and liquidity provision by the central bank," Proceedings, Federal Reserve Bank of Cleveland, pages 611-640.
- Freixas, Xavier & Parigi, Bruno & Rochet, Jean-Charles, 1999. "Systemic Risk, Interbank Relations and Liquidity Provision by the Central Bank," CEPR Discussion Papers 2325, C.E.P.R. Discussion Papers.
- Xavier Freixas & Bruno Parigi & Jean Charles Rochet, 1998. "Systemic risk, interbank relations and liquidity provision by the Central Bank," Economics Working Papers 440, Department of Economics and Business, Universitat Pompeu Fabra, revised Sep 1999.
- Diamond, Douglas W & Dybvig, Philip H, 1983.
"Bank Runs, Deposit Insurance, and Liquidity,"
Journal of Political Economy,
University of Chicago Press, vol. 91(3), pages 401-419, June.
- Rodrigo Cifuentes & Gianluigi Ferrucci & Hyun Song Shin, 2005.
"Liquidity risk and contagion,"
Bank of England working papers
264, Bank of England.
- Yaron Leitner, 2005. "Financial Networks: Contagion, Commitment, and Private Sector Bailouts," Journal of Finance, American Finance Association, vol. 60(6), pages 2925-2953, December.
- Larry Eisenberg & Thomas H. Noe, 2001. "Systemic Risk in Financial Systems," Management Science, INFORMS, vol. 47(2), pages 236-249, February.
- Lagunoff, Roger & Schreft, Stacey L., 2001.
"A Model of Financial Fragility,"
Journal of Economic Theory,
Elsevier, vol. 99(1-2), pages 220-264, July.
When requesting a correction, please mention this item's handle: RePEc:nbr:nberwo:14997. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: ()
If references are entirely missing, you can add them using this form.