Fragility of Reputation and Clustering in Risk-Taking

I study the interplay between reputation and risk-taking in a dynamic stochastic environment where it is ex-ante efficient for firms to engage in safe projects, but ex-post preferred to invest in risky ones, appropriating surplus from lenders. By introducing fundamentals, I interpret the model as a dynamic global game in which strategic complementarities arise endogenously from reputation updating, overcoming pervasivemultiple equilibria. I find that even though reputation deters opportunistic behavior, it introduces fragile incentives which may lead to large changes in aggregate risk-taking in response to small changes in aggregate fundamentals, inducing financial crises and credit crunches. ∗UCLA Economics Department. [email protected]. I would like to specially thank Andy Atkeson and David K. Levine for their unwavering support and advice. I also thank V.V. Chari, Christian Hellwig, Hugo Hopenhayn, Lee Ohanian, Narayana Kocherlakota, Chris Phelan and Bill Zame for excellent suggestions and to participants at the UCLA Macroeconomics, IO and Theory Proseminars and at the Minneapolis Fed for their comments. First version: July 2007. The usual waiver of liability applies.