Towards a Russian doll model of financial fragility and corporate governance

We show that the phenomenology of sources of financial instabilities can be traced back to the iteration of a single and conceptually simple step: the pooling of cash-flows priced at different levels of resolution of price-relevant information. We illustrate this with examples from bond rating, bond pricing, deposit insurance pricing, various kinds of regulatory arbitrage, risk-adjusted capital allocation, persistent mispricing of risk, the impact of accounting for Level-3 assets, the design problem for a special resolution regime and financial implications of the process of financial reform itself. We find that conflicts between the financial interests of various stakeholders can be viewed as examples of tranche wars from the point of view of abstract synthetic re-securitizations of pools of cash-flows.