"In terms of regulation, there was really very little attention to how the financial system worked as a whole," said Arinaminpathy, who is a postdoctoral research associate in Princeton's Department of Ecology and Evolutionary Biology.
"When looking only at individual institutions, big is beautiful because larger banks can more easily diversify their assets," Arinaminpathy said. "But a system-level perspective reveals that when a big bank goes down its impact is much bigger than its size regardless of diversity. We wanted a modeling framework to explore how big that effect could be and how to lessen its intensity."
In addition, said second author Sujit Kapadia, a Bank of England financial-policy adviser, the models demonstrate how a lack of confidence perpetuates a financial crisis. That fear manifests as "liquidity hoarding," wherein banks stop lending to one another. Unlike a virus, financial contagion only spreads more quickly and widely when banks "quarantine" themselves by freezing loans and cutting business ties. That, in turn, feeds distress, which further fuels withdrawal from the system. This power of fear to promote failure was evident following the collapse of Lehman Brothers Holdings Inc. in 2008, which was a major driver of the global crisis, Kapadia said.
"After Lehman Brothers failed in 2008, confidence disappeared from the system rather suddenly and the system just fell off a precipice," Kapadia said. "The speed and sharpness of that collapse in confidence was more than might have been expected before the crisis, and is one of the reasons we tried to buil
|Contact: Morgan Kelly|