This paper studies the full equilibrium dynamics of an economy with financial frictions. Due to highly non-linear amplification effects, the economy is prone to instability and occasionally enters volatile episodes. Risk is endogenous and asset price correlations are high in down turns. In an environment of low exogenous risk experts assume higher leverage making the system more prone to systemic volatility spikes- a volatility paradox. Securitization and derivatives contracts leads to better sharing of exogenous risk but to higher endogenous systemic risk. Financial experts may impose a negative externality on each other by not maintaining adequate capital cushion.

How did the Subprime Crisis, a problem in a small corner of U.S. financial markets, affect the entire global banking system? To shed light on this question we use principal components analysis to identify common factors in the movement of banks ’ credit default swap spreads. We find that fortunes of international banks rise and fall together even in normal times along with short-term global economic prospects. But the importance of common factors rose steadily to exceptional levels from the outbreak of the Subprime Crisis to past the rescue of Bear Stearns, reflecting a diffuse sense that funding and credit risk was increasing. Following the failure of Lehman Brothers, the interdependencies briefly increased to a new high, before they fell back to the pre-Lehman elevated levels – but now they more clearly reflected heightened funding and counterparty risk. After Lehman’s failure, the prospect of global recession became imminent, auguring the further deterioration of banks ’ loan portfolios. At this point the entire global financial system had become infected. 1

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The “shadow ” banking system played a major role in the financial crisis, but was not a central focus of the recent Dodd-Frank Law and thus remains largely unregulated. This paper proposes principles for the regulation of shadow banking and describes a specific proposal to implement those principles. We first document the rise of shadow banking over the last three decades, helped by regulatory and legal changes that gave advantages to three main institutions of shadow banking: money-market mutual funds (MMMFs) to capture retail deposits from traditional banks, securitization to move assets of traditional banks off their balance sheets, and repurchase agreements (“repo”) that facilitated the use of securitized bonds in financial transactions as a form of money. A central idea of this paper is that the evolution of a bankruptcy “safe harbor” for repo has been a crucial feature in the growth and efficiency of shadow banking, and so regulators can use access to this safe harbor as the lever to enforce new rules. As for the rules themselves, history has demonstrated two successful methods for the regulation of privately created money: strict guidelines on collateral (used to stabilize national bank notes in the 19 th century), and government-guaranteed insurance (used to stabilize demand deposits in the 20 th

credit risk transfers and the

Abstract: In this postmortem, I find that the design, implementation, and maintenance of financial policies during the period from 1996 through 2006 were primary causes of the financial system’s demise. The evidence is inconsistent with the view that the collapse of the financial system was caused only by the popping of the housing bubble (“accident”) and the herding behavior of financiers rushing to create and market increasingly complex and questionable financial products (“suicide”). Rather, the evidence indicates that regulatory agencies were aware of the growing fragility of the financial system due to their policies and yet chose not to modify those policies, suggesting that “negligent homicide” contributed to the financial system’s collapse.

The recent financial crisis revealed several weaknesses in the global financial system, one of the most important being the high degree of interconnectedness among market participants and a lack of transparency regarding

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We develop a dynamic model of debt runs on a firm, which invests in an illiquid asset by rolling over staggered short-term debt contracts. We derive a unique threshold equilibrium, in which creditors coordinate their asynchronous rollover decisions based on the firm’s publicly observable and time-varying fundamental. Fear of the firm’s future rollover risk motivates each maturing creditor to run ahead of others even when the firm is still solvent. Our model provides implications on the roles played by volatility, illiquidity and debt maturity in driving debt runs, as well as on firms’capital adequacy standards and credit risk.

ABSTRACT. This paper studies a macroeconomic model in which financial experts borrow from less productive agents in order to invest in financial assets. We pursue three set of results: (i) Going beyond a steady state analysis, we show that adverse shocks cause amplifying price declines not only through the erosion of net worth of the financial sector, but also through increased price volatility, leading to precautionary hoarding and fire sales. (ii) Financial sector’s leverage and maturity mismatch is excessive, since it does not internalize externalities it imposes on the labor sector and other financial experts due to a fire-sale externality. (iii) Securitization, which allows the financial sector to offload some risk, exacerbates the excessive risk-taking. † We thank Nobu Kiyotaki, Hyun Shin and seminar participants at Princeton, HKU Theory Conference,