Modern financial institutions are large, complex, and
highly interconnected. In the wake of the financial crisis
of 2007-2009, commentators and policymakers have given
considerable attention to large institutions, particularly
those that can become "too-big-to-fail." This Article takes
a novel approach to this general problem. It begins by
asking a foundational question: given the extraordinary
volume of transactions between large, complex
institutions, what mechanisms do they use to protect
themselves from the risks created by their complexity, and
how do those mechanisms affect the stability of the
financial system? To keep the problem manageable, the
Article focuses on one type of transaction, albeit a critical
one: collateralized loans.
The Article shows that in the period leading to the recent
crisis, financial institutions dealt with complexity by
transacting "blindly"-without acquiring any real
information about the other party to the transaction.
While this may appear counterintuitive, the Article
develops a theory of "blind-debt" contracting that explains
why willful ignorance makes sense, at least from an
economic perspective. The Article also shows that while
blind debt minimizes a lender's transactional risks, as the
number of transactions increase, so does the risk the
system will experience a "sudden switch" from a blind-debt
equilibrium to one in which lenders value transparency. A
number of features of the recent crisis provide support for
the theory developed in the Article.
Utset, Utset A.
"Complex Financial Institutions and Systemic Risk,"
Georgia Law Review: Vol. 45:
3, Article 4.
Available at: https://digitalcommons.law.uga.edu/glr/vol45/iss3/4