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Fire Sales in a Model of Complexity

Authors

  • RICARDO J. CABALLERO,

  • ALP SIMSEK

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    • Both the authors are from MIT and NBER. We thank Jeff Campbell, John Geanakoplos, Campbell Harvey, David Laibson, Fred Malherbe, Juan Ocampo, Katerina Smidkova, Fernando Vega-Redondo, Adam Zawadowski, an anonymous referee, and an Associate Editor for valuable comments. We also thank the seminar participants at Bilkent University, Boston College, The Federal Reserve Bank of Boston, Boston University, Harvard University, MIT, Middle East Technical University, New York University, the University of Chicago, the University of Michigan; conference participants at the AEA meetings, Brown University, CIED-Tel Aviv University, Columbia University, ECB, IRFMP, MFI, MNB-CEPR, PSU-Cornell, SAET, SED for their comments; and the NSF for financial support. This paper covers and extends the substantive issues in (and hence, replaces) “Complexity and Financial Panics,” NBER WP #14997.


ABSTRACT

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.

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