Financial Entanglement: A Theory of Incomplete Integration, Leverage, Crashes, and Contagion

Investors, firms, and intermediaries are located on a circle. Intermediaries facilitate risk sharing by allowing investors at their location to invest in  firms at other locations. Access to markets is not frictionless, but involves participation costs that increase with distance. Asset prices, the extent of market integration, the extent of cross-location capital flows, and the resources devoted to the financial industry are jointly determined in equilibrium. Although investors at any location are identical to each other, we find that the financial sector may exhibit diversity, with some financial intermediaries in every location offering high-leverage, high-participation, and high-fee structures and some intermediaries offering unlevered, low-participation, and low-fee structures. The capital attracted by high-leverage strategies is vulnerable to even small changes in market access costs, leading to discontinuous price drops and portfolio-flow reversals. Moreover, an adverse shock to intermediaries at a subset of locations causes contagion, in the sense that it affects prices everywhere.

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