Fire Sales in a Model of Complexity

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,...

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Bibliographic Details
Published in:The Journal of finance (New York) 2013-12, Vol.68 (6), p.2549-2587
Main Authors: CABALLERO, RICARDO J., SIMSEK, ALP
Format: Article
Language:English
Subjects:
Bank assets
Bank liquidity
Bank markets
Banking crises
Bankruptcy
Banks
Complexity
Conceptualization
Economic crisis
Economic models
Economic uncertainty
Endogenous
Externalities
Financial crisis
Financial risk
Flight to quality
Legacies
Payments
Risk
Risk exposure
Risk management
Sales
Studies
Uncertainty
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Summary: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.
ISSN:0022-1082
1540-6261
DOI:10.1111/jofi.12087