Catastrophe theory and the financial crisis

This paper develops and estimates catastrophe‐augmented models of the financial crisis. We employ catastrophe theory to explain discontinuous jumps in state variables of dynamic systems. We estimate an augmented bank failure model showing that the buildup of risk and an increase in the Federal Funds rate combined with low reserves (negative insurance effect) have been the main drivers of the financial crisis. Therefore, macroprudential policy and rating agencies play a key role in preventing the buildup of (systemic) risk and preventing the economy from entering a bifurcation area.