Risk Averse Banks and Uncertain Correlation Values: A Theory of Rational Bank Panics

We present a model for Financial fragility in which banks are risk-averse portfolio managers and there is uncertainty over risk management parameters. There is a danger of heightened risk aversion and projects in small economies are assumed to be riskier than those in large economies. In this situation there is a danger that a rise in project correlations will lead to a rational but unnecessary credit crunch. We conclude firstly that greater transparency in the dissemination of correlation parameters is desirable and secondly that regulators should respond to heightened financial fragility by relaxing capital adequacy requirements.