A model of financial fragility

This article presents a dynamic, stochastic game-theoretic model with two essential features. First. agents hold diversified portfolios that link their financial positions to those of other agents, Second, shocks to fundamentals at the initial date cause some portfolio losses. Agents who incur losses reallocate their portfolios, thereby breaking some linkages. In the Pareto-efficient symmetric equilibrium studied, two related types of financial crisis can occur in response. One occurs gradually as losses spread, breaking more links. The other type occurs instantaneously when forward-looking agents preemptively shift to safer portfolios to avoid future losses from contagion. An economy is more fragile the earlier its last remaining link breaks from Such a crisis. (C) 2001 Academic Press.