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A Model of Financial Fragility

  • Roger Lagunoff

    (Georgetown University)

  • Stacey L. Schreft

    (Federal Reserve Bank of Kansas)

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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Paper provided by EconWPA in its series Game Theory and Information with number 9803001.

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Date of creation: 10 Mar 1998
Date of revision: 30 Apr 1998
Handle: RePEc:wpa:wuwpga:9803001
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  1. Rochet, Jean-Charles & Tirole, Jean, 1996. "Interbank Lending and Systemic Risk," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 28(4), pages 733-62, November.
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  3. repec:tpr:qjecon:v:107:y:1992:i:3:p:797-817 is not listed on IDEAS
  4. Russell Cooper & Dean Corbae, 1997. "Financial Fragility and the Great Depression," NBER Working Papers 6094, National Bureau of Economic Research, Inc.
  5. Atkeson, Andrew & Rios-Rull, Jose-Victor, 1996. "The balance of payments and borrowing constraints: An alternative view of the Mexican crisis," Journal of International Economics, Elsevier, vol. 41(3-4), pages 331-349, November.
  6. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, vol. 51(3), pages 393-414, July.
  7. 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.
  8. Cole, Harold L & Kehoe, Timothy J, 2000. "Self-Fulfilling Debt Crises," Review of Economic Studies, Wiley Blackwell, vol. 67(1), pages 91-116, January.
  9. Hiroshi Fujiki & Edward J. Green & Akira Yamazaki, 1999. "Sharing the risk of settlement failure," Working Papers 594, Federal Reserve Bank of Minneapolis.
  10. Bikhchandani, Sushil & Hirshleifer, David & Welch, Ivo, 1992. "A Theory of Fads, Fashion, Custom, and Cultural Change in Informational Cascades," Journal of Political Economy, University of Chicago Press, vol. 100(5), pages 992-1026, October.
  11. Nobuhiro Kiyotaki & John Moore, 1997. "Credit Chains," ESE Discussion Papers 118, Edinburgh School of Economics, University of Edinburgh.
  12. Frederic S. Mishkin, 1990. "Asymmetric Information and Financial Crises: A Historical Perspective," NBER Working Papers 3400, National Bureau of Economic Research, Inc.
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