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ability to verify the quality of borrowers. According to Van Order, a small change in economic fundamentals that made borrowers more nervous about financial markets caused some borrowers to move their savings from financial markets to banks. Such a change would raise the costs of borrowing in financial markets, which could prompt high-quality borrowers to try to get loans from banks rather than financial markets. This could snowball as all the good borrowers stop getting loans from financial markets, prompting lenders to charge still higher rates to those who remain prompting still more borrowers to switch. This process is called an
105:. Under this view, depositors would not normally trust banks with their deposits because they fear that when they want to withdraw their money, the bank may try to avoid repaying, or try to repay at a lower rate. However, if the bank does not have enough liquid assets to cover all depositor claims, a refusal to pay any one depositor the promised amount will prompt all other depositors to try to withdraw as well, and effectively cut off all lending to the bank. Banks voluntarily submit themselves to the risk of a
118:
investors to change their portfolio could cause others to take losses. If these losses are large enough to prompt further portfolio changes, a small change could initiate a chain reaction of losses. Moreover, Lagunoff and
Schreft argue that investors will anticipate the possibility of such a chain reaction, so that the belief that it may happen in the future could cause investors to reallocate their portfolios, thus triggering a self-fulfilling crisis.
302:
participants. As a result, the reliance on cheap short term funding creates a negative risk externality (Perotti and Suarez, 2011). Some economists propose that the government tax or limit such liabilities to reduce such excessive risk-taking. Perotti and Suarez (2009) proposed prudential
Pigouvian charges on unstable short term funding, while Shin (2010) targets unstable foreign flows. Others have supported this approach.
245:
country's own currency. Yet often the returns of the borrower's project will be in the domestic currency. This is a source of financial fragility, because a drop in the exchange rate can cause a debt crisis, as debt denominated in foreign currency becomes much more expensive. A third view holds that the fundamental cause of international financial fragility is a lack of
23:. Franklin Allen and Douglas Gale define financial fragility as the degree to which "...small shocks have disproportionately large effects." Roger Lagunoff and Stacey Schreft write, "In macroeconomics, the term "financial fragility" is used...to refer to a financial system's susceptibility to large-scale financial crises caused by small, routine economic shocks."
281:. Under one proposed system, countries would be divided into groups that would have free capital flows among the group's members, but not between the groups. A system would be put in place such that in the event of a crisis, capital flows out of the affected countries could be cut off automatically in order to isolate the crisis. This system is partly modeled on
156:. They show that even in such an economy there will still be significant fluctuations arising solely from these vanishingly small financial shocks. In their view, banks are risk-sharing institutions where deposits act to insure depositors against a lack of access to money. Even minuscule shocks can set off self-reinforcing price changes.
139:
such as a bank. Banks are better able to verify the quality of borrowers, but they charge a fee for their services in the form of lower returns to their depositors then the full returns on the investments. Financial markets allow lenders to circumvent banks and avoid this fee, but they lose the banks
117:
Economists Roger
Lagunoff and Stacey Schreft have argued that financial fragility arises from linked portfolios of investors. If investors have linked portfolios such that if one investor withdraws funds the investment will fail and the other investor will also take a loss, then any event that causes
84:
between depositors and borrowers. Depositors want immediate access to their deposits, while borrowers are not able to pay on demand. This creates a fundamental fragility, as a bank's assets cannot be liquidated in the event of a crisis to pay all depositors. This tension makes the financial system
189:), policy-makers would like to convince banks that they will not bail them out in the event of a crisis so that banks do not adopt a fragile capital structure. However, if policy-makers announce that they will not bail out banks in the event of a crisis, bankers will not believe them because they
301:
As described above, many economists believe that financial fragility arises when financial agents such as banks take on too many or too illiquid liabilities relative to the liquidity of their assets. Note that asset liquidity is also a function of the degree of stable funding available to market
244:
is a form of implicit guarantee, and leads market participants to expect such bailouts. A second view is that, due to lack of confidence in a country's currency, borrowers in that country seeking financing will not be able to borrow long-term, or borrow from international lenders at all, in that
220:. Given this, banks have an incentive to imitate other banks so that they achieve their worse losses when everyone else does, and thus maximally benefit from the bailout or other policies. This leads banks to adopt a particularly fragile capital structure, so that they all fail together.
176:
against downside risks. If the government is considered likely to step in and reduce losses incurred by banks, bankers will have an incentive to take on more risk and increase the financial fragility of the banking system. In general, a bailout is the optimal response of policy-makers
289:, which are typically well-integrated in order to prevent shortages due to unusually high demand for electricity in one part of the network, but that have circuit breakers in place to prevent damage to the network in one part of the grid from causing a
152:
Franklin Allen and
Douglas Gale discuss financial fragility as large effects from small shocks. They formalize this idea by considering the case of an economy in which the size of financial shocks
249:
to enforce contracts between parties. This lack of strong contracts makes lenders suspicious of borrowers, and can prompt a crisis should lenders begin to suspect that borrowers will not repay.
135:
problem in financial markets. According to Van Order, lenders can choose to make loans to borrowers directly through financial markets such as the stock market, or to operate through a
144:, and could lead to the sudden collapse of a financial market. The opposite effect might also occur, leading to a large-scale change in the capital structure in the other direction.
131:
Economist Robert Van Order argued in 2006 that a small change in economic fundamentals can prompt a large change in asset prices and financial structure due to the
109:
so that depositors will trust them with their loans, since depositors know that the bank will not be able to get away with their money without prompting a run.
51:
view, the economy may always be vulnerable to a financial crisis whose onset may be triggered by some random external event, or simply be the result of
193:
that policy-makers will in fact bail them out in the event of a crisis. Policy-makers stated policy of no bailouts in the event of a crisis is not
35:
that makes them vulnerable to financial crises? There are two views of financial fragility which correspond to two views on the origins of
216:
and Jean Tirole have argued that policy in response to a crisis naturally gives greater benefits to those banks that have taken on more
212:
the CEO of
Citigroup was quoted as saying, "As long as the music is playing, you have to get up and dance." More formally, economists
509:
Diamond, Douglas; Raghuran Rajan (April 2001). "Liquidity Risk, Liquidity
Creation, and Financial Fragility: A Theory of Banking".
43:
view, financial crises arise from the poor fundamentals of the economy, which make it vulnerable during a time of duress such as a
310:
Another form of financial regulation designed to reduce financial fragility is to regulate bank's balance sheets directly via
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810:
236:
describe three views on the connection between exchange rate regimes and financial fragility. One view relates to the
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228:
An important aspect of financial fragility of the international system is the connection to exchange rate regimes.
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The natural financial fragility of banking systems is seen by many economists as an important justification for
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created by the belief of market participants that governments will provide bailouts in the event of a crisis. A
185:), because the bailout will reduce the negative effects of the crisis on the economy. Before the crisis occurs (
554:
Lagunoff, Roger; Stacey
Schreft (August 1999). "Financial Fragility with Rational and Irrational Exuberance".
101:
Economists
Douglas Diamond and Raghuram Rajan argued that banks purposefully adopt a fragile structure as a
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to act as circuit breakers to prevent crises from spreading from one country to another, a process called
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Why does the financial system exhibit fragility in the first place? Why do banks choose to take on a
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Another reason banks might adopt a fragile financial structure is because they expect a government
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Allen, Franklin; Douglas Gale (Dec 2004). "Financial
Fragility, Liquidity, and Asset Prices".
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Van Order, Robert (April 2006). "A Model of
Financial Structure and Financial Fragility".
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Krugman, Paul, "Balance Sheets, the Transfer Problem, and Financial Crises", Draft 1999,
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Stiglitz, Joseph (May 2010). "Capital Flows, Contagion, and Regulatory Responses".
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Diamond DW, Dybvig PH (1983). "Bank runs, deposit insurance, and liquidity".
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Lagunoff, Roger; Stacey Schreft (2001). "A Model of Financial Fragility".
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Moreover, some economists have argued that the presence of bailouts will
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670:"Collective Moral Hazard Maturity Mismatch and Systemic Bailouts"
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banks to take on more risk than they would like. In 2007,
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in the event of a financial crisis. This is an example of
730:"Securitization, Shadow Banking, and Financial Fragility"
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due to the inherent nature of banking. Banks serve as
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throughout all houses connected through the network.
771:American Economic Review: Papers and Proceedings
19:is the vulnerability of a financial system to a
646:Federal Reserve Bank of New York Staff Reports
39:. According to the fundamental equilibrium or
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357:Journal of the European Economic Association
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632:
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261:designed to reduce financial fragility.
692:"Exchange Rates and Financial Fragility"
441:http://web.mit.edu/krugman/www/FLOOD.pdf
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72:, financial systems are vulnerable to a
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690:Eichengreen, Barry; Ricardo Hausmann.
658:Quoted in Farhi-Tirole AER Forthcoming
47:. According to the self-fulfilling or
601:Journal of Money, Credit, and Banking
333:"Another Kind of Financial Fragility"
7:
677:NBER Working Paper (AER Forthcoming)
556:Journal of Money, Credit and Banking
224:Connection to exchange rate regimes
639:"Bailouts and Financial Fragility"
85:susceptible to a sudden change in
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709:Krugman, Paul (11 January 2010).
331:Krugman, Paul (4 February 2011).
201:banks will take on excess risk.
637:Keister, Todd (September 2010).
511:The Journal of Political Economy
668:Farhi, Emmanuel; Jean Tirole.
89:by depositors, resulting in a
27:Sources of financial fragility
1:
455:Journal of Political Economy
253:Reducing financial fragility
59:Self-fulfilling crisis views
273:have argued for the use of
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405:Journal of Economic Theory
379:10.1162/jeea.2004.2.6.1015
269:Some economists including
179:once a crisis has occurred
696:NBER Working Paper Series
197:, so in the absence of a
142:adverse selection spiral
122:Fundamental crisis views
711:"Too big to fail fail?"
728:Stein, Jeremy (2010).
427:10.1006/jeth.2000.2733
137:financial intermediary
133:asymmetric information
783:10.1257/aer.100.2.388
613:10.1353/mcb.2006.0047
493:Fed Res Bank Mn Q Rev
191:rationally anticipate
747:10.1162/DAED_a_00041
312:capital requirements
306:Capital requirements
259:financial regulation
242:pegged exchange rate
70:Diamond-Dybvig model
283:electrical networks
279:financial contagion
49:sunspot equilibrium
17:Financial fragility
811:Financial problems
715:The New York Times
337:The New York Times
297:Taxing liabilities
490:Reprinted (2000)
230:Barry Eichengreen
199:commitment device
103:commitment device
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698:(WP 7418).
318:References
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621:201775516
564:CiteSeerX
519:CiteSeerX
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413:CiteSeerX
365:CiteSeerX
174:insurance
45:recession
805:Category
791:10229639
756:57566087
734:Daedalus
541:32078187
486:14214187
291:blackout
285:such as
218:leverage
195:credible
160:Bailouts
107:bank run
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586:2601071
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