Interconnectedness, systemic crises, and recessions

In this paper, we construct a simple model designed to capture four widely held views about financial crises: [1] Interconnectedness among financial institutions (banks) can play a major role in precipitating systemic financial crises. [2] It does so by introducing loan-portfolio opacity, reducing the quality of information about portfolio risk. [3] Financial crises, particularly systemic ones, often are followed by serious recessions. [4] A loss of confidence in the financial system is partly responsible for the length and severity of these recessions. In the model, banks assess loan risk, originate and liquidate loans, and acquire loans originated by other banks. Interconnectedness of this sort can obscure information, resulting in banks making inefficient decisions about liquidating loans and choosing loan originators (who assess risk). Inefficient liquidation can deepen recessions and lead to systemic financial crises; less effective risk assessment can increase the probability of lengthy, severe recessions. The government may wish to increase the transparency of bank portfolios by limiting interconnectedness. The optimal degree of regulation may depend on depositors' degree of risk aversion and may not eliminate financial crises.