Financial crises and the evaporation of trust

TL;DR

This paper presents a simple model illustrating how trust breakdowns in financial systems can spread rapidly and are difficult to restore, shedding light on the mechanisms behind credit freezes during financial crises.

Contribution

It introduces a novel model combining coordination games and network growth to explain trust erosion and recovery in financial markets, inspired by the 2007/8 crisis.

Findings

Trust loss can spread system-wide rapidly.

Restoring trust requires significant effort due to hysteresis.

The model aligns with the sequence of events in the 2007/8 financial crisis.

Abstract

Trust lies at the crux of most economic transactions, with credit markets being a notable example. Drawing on insights from the literature on coordination games and network growth, we develop a simple model to clarify how trust breaks down in financial systems. We show how the arrival of bad news about a financial agent can lead others to lose confidence in it and how this, in turn, can spread across the entire system. Our results emphasize the role of hysteresis -- it takes considerable effort to regain trust once it has been broken. Although simple, the model provides a plausible account of the credit freeze that followed the global financial crisis of 2007/8, both in terms of the sequence of events and the measures taken (and being proposed) by the authorities.