Fire Sales in a Model of Complexity

We present a model of …nancial crises that stem from endogenous complexity. We conceptualize complexity as banks’uncertainty about the …nancial network of cross-exposures. As conditions deteriorate, cross-exposures generate the possibility of a domino e¤ect of bankruptcies. As this happens, banks face an increasingly complex environment since they need to understand a greater fraction of the …nancial network to assess their counterparty risk. We show that complexity dramatically ampli…es banks’perceived counterparty risk, and makes relatively healthy banks, and hence potential asset buyers, reluctant to buy. Our mechanism takes place in an otherwise stable (by construction) network of limited cascades. The model features a complexity externality which provides a rationale for various government policies used during the Subprime and European crises, including bailouts and asset