[1] Franklin Allen and Douglas Gale define financial fragility as the degree to which "...small shocks have disproportionately large effects.
According to the self-fulfilling or sunspot equilibrium view, the economy may always be vulnerable to a financial crisis whose onset may be triggered by some random external event, or simply be the result of herd mentality.
This tension makes the financial system susceptible to a sudden change in demand for money by depositors, resulting in a bank run.
[5] Economists Douglas Diamond and Raghuram Rajan argued that banks purposefully adopt a fragile structure as a commitment device.
[6] Economists Roger Lagunoff and Stacey Schreft have argued that financial fragility arises from linked portfolios of investors.
[8] Franklin Allen and Douglas Gale discuss financial fragility as large effects from small shocks.
Policy-makers stated policy of no bailouts in the event of a crisis is not credible, so in the absence of a commitment device banks will take on excess risk.
"[10] More formally, economists Emmanuel Farhi and Jean Tirole have argued that policy in response to a crisis naturally gives greater benefits to those banks that have taken on more leverage.
Barry Eichengreen and Ricardo Hausmann describe three views on the connection between exchange rate regimes and financial fragility.
One view relates to the moral hazard created by the belief of market participants that governments will provide bailouts in the event of a crisis.
A third view holds that the fundamental cause of international financial fragility is a lack of institutions to enforce contracts between parties.
[13] [14] Some economists including Joseph Stiglitz have argued for the use of capital controls to act as circuit breakers to prevent crises from spreading from one country to another, a process called financial contagion.
As a result, the reliance on cheap short term funding creates a negative risk externality (Perotti and Suarez, 2011).