Too Much Right can Make a Wrong: Setting the Stage for the Financial Crisis

38 Pages Posted: 5 Dec 2009

See all articles by Richard J. Rosen

Richard J. Rosen

Federal Reserve Bank of Chicago - Economic Research

Date Written: November 1, 2009

Abstract

The financial crisis that started in 2007 exposed a number of flaws in the financial system. Many of these flaws were associated with financial instruments that were issued by the shadow banking system, especially securitized assets. The volume and complexity of securitized assets grew rapidly during run-up to the financial crisis that began in 2007. The paper discusses how the financial crisis can be viewed as a possible but logical outcome of a system where investors are overconfident, busy, and investing other peoples’ money and intermediaries are set up to take advantage of investors’ tendencies. The investor-intermediary risk cycle in this crisis is common to other crises. However, there are a number of factors that may have made the 2007 crisis more severe. Among them are the length of the pre-crisis period, the shift from financial intermediaries to the shadow banking system, the increasing interconnectedness among financial firms, and the increased leverage at some financial firms.

Keywords: Financial crisis, investor behavior, overconfidence

JEL Classification: G01, G18, G24

Suggested Citation

Rosen, Richard J., Too Much Right can Make a Wrong: Setting the Stage for the Financial Crisis (November 1, 2009). FRB of Chicago Working Paper No. 2009-18, Available at SSRN: https://ssrn.com/abstract=1517950 or http://dx.doi.org/10.2139/ssrn.1517950

Richard J. Rosen (Contact Author)

Federal Reserve Bank of Chicago - Economic Research ( email )

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