An oldie but goodie ftom Axel Leijonhufvud...

Here is a snippet from an old blog post by one of my favourite economists, Axel Leijonhufvud:

"Systemic problems
The currently pressing problems all concern instabilities that have been neglected in stable-with-frictions macro theory. They constitute three themes I discussed in more detail in previous Vox columns (Leijonhufvud, June 2007, January 2009, and July 2009).

• Instability of leverage. Competing to achieve rates of return several times higher than returns in industry, financial institutions were at historically high levels of leverage towards the end of the boom, earning historically minimal risk spreads – and carrying large volumes of assets soon to be revealed as “toxic.”
• Connectivity. In the US, under the Glass-Steagall regulations, the financial system had been segmented into distinct industries each characterized by the type of assets they could invest in and liabilities they could issue. Firms in different industry segments were not in direct competition with each other. Deregulation has dramatically increased connectivity in the global network of financial institutions. The crisis of the American savings and loan industry in the 1980s, although costly enough, was confined to that market segment. The present crisis also started in American home finance but has spread and amplified across the world."

The whole post (plus all the linked materials) is well worth reading.  The above snippet gets at the heart of what I am trying to show with my first year PhD paper.  Increasing connectivity in the financial sector (which I am modelling as increasing network density), increases the leverage of financial institutions (either because increasing connectivity lowers borrowing costs, financial institutions are risk averse, etc).  Increased leverage makes the financial system fragile and vulnerable to idiosyncratic shocks despite the increased diversification brought about by the additional connectivity.