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Financial Innovation, Macroeconomic Stability and Systemic Crises


  •  This article represents the views of the authors and should not be thought to represent those of the Bank of England or Monetary Policy Committee members. We are grateful to Jagjit Chadha, John Eatwell, Andrew Glyn, Andy Haldane, Roman Inderst, Nigel Jenkinson, Karsten Jeske, Nobu Kiyotaki, Arvind Krishnamurthy, Bill Nelson, Tanju Yorulmazer, two anonymous referees, and seminar participants at the Bank of England, the London School of Economics, the Federal Reserve Bank of Atlanta conference on ‘Modern Financial Institutions, Financial Markets, and Systemic Risk’, the CERF conference on ‘The Changing Nature of the Financial System and Systemic Risk’, the 2006 European and North American Summer Meetings of the Econometric Society, the Federal Reserve Bank of San Francisco conference on ‘Financial Innovations and the Real Economy’, the 2007 RES conference, and the FMG conference on ‘Cycles, Contagion and Crises’ for helpful comments and suggestions. Ander Perez gratefully acknowledges financial support from the Fundacion Rafael del Pino.


We present a general equilibrium model of intermediation designed to capture some of the key features of the modern financial system. The model incorporates financial constraints and state-contingent contracts, and contains a clearly defined pecuniary externality associated with asset fire sales during periods of stress. If a sufficiently severe shock occurs during a credit expansion, this externality is capable of generating a systemic financial crisis that may be self-fulfilling. Our model suggests that financial innovation and greater macroeconomic stability may have made financial crises in developed countries less likely than in the past but potentially more severe.