A model of financial fragility

This article presents a dynamic, stochastic game-theoretic model with two e ssential features. First. agents hold diversified portfolios that link thei r financial positions to those of other agents, Second, shocks to fundament als at the initial date cause some portfolio losses. Agents who incur losse s reallocate their portfolios, thereby breaking some linkages. In the Paret o-efficient symmetric equilibrium studied, two related types of financial c risis can occur in response. One occurs gradually as losses spread, breakin g more links. The other type occurs instantaneously when forward-looking ag ents preemptively shift to safer portfolios to avoid future losses from con tagion. An economy is more fragile the earlier its last remaining link brea ks from Such a crisis. (C) 2001 Academic Press.