In the preceding two chapters, we separately considered the operation of asset markets and intermediaries, such as banks. In the present chapter, we combine these elements and begin the study of their interaction. From this we will gain important insight into the phenomenon οι financial fragility. We use the phrase [financial fragility] to describe situations in which small shocks have a significant impact on the financial system. One source of financial fragility is the crucial role of liquidity in the determination of asset prices. There are many historical illustrations of this phenomenon. For example, Kindleberger (1978, pp. 107–108) argues that the immediate cause of a financial crisis
maybe trivial, a bankruptcy, a suicide, a flight, a revelation, a refusal of credit to some
borrower, some change of view which leads a significant actor to unload. Prices fall.
Expectations are reversed. The movement picks up speed. To the extent that speculators
are leveraged with borrowed money, the decline in prices leads to further calls on them
for margin or cash, and to further liquidation. As prices fall further, bank loans turn
sour, and one or more mercantile houses, banks, discount houses, or brokerages fail.
The credit system itself appears shaky and the race for liquidity is on.
A particularly interesting historical example is the financial crisis of 1763 documented by Schnabel and Shin (2004). The banks in those days were different from modern commercial banks. They did not take in deposits and make loans. Instead the [bankers] were merchants involved in the trade of goods such as wheat (this is where the term [merchant banker] comes from). Their primary financial role was to facilitate payments between parties using bills of exchange. A bill was like an IOU in which one party acknowledged that he had received a delivery of wheat, say, and promised payment at a specified future date. Sometimes reputable bankers could make their creditworthiness available to others, by allowing people known to them to draw bills on them in exchange for a fee. These bills could then be used as a means of payment or to raise capital by selling the bill in the capital market. The widespread use of these bills in financial centers, such as Amsterdam and Hamburg, led to interlocking claims among bankers.
The de Neufville brothers' banking house in Amsterdam was one of the most famous in Europe at the time. The end of the Seven Years War led to an