Essentially, investors switched from believing that returns behaved according to a tight and well-behaved distribution to one in which they had very little idea about the likely distribution of returns – a state of virtual Knightian uncertainty (Caballero and Krishnamurthy, 2008). There was also a higher-order information problem arising out of the interconnected nature of the financial system. Banks, when they appear at all in economic models, just exist to transfer funds from savers to borrowers and to monitor the latter. But the reality is a high degree of exposure of financial institutions to each other as a result of interbank loans, holdings of CDSs written by other parties, holdings of securities issued by other parties, and so on. In normal times, one does not need to know much about a counterparties’ risk exposure. But when there are doubts about solvency of a major institution, one needs to know not only one’s own exposure to that institution, but also about the exposure of one’s other counterparties. The collapse of Lehman Brothers was particularly critical in that, prior to that and particularly in the light of the rescue of Bear Stearns, such an institution was probably viewed as being too big and interconnected to fail. But the failure of the US authorities to put together a viable rescue plan, together with growing doubts about the likely effectiveness of the Troubled  6  As it turned out, those willing to carry the risk were not always those best placed to bear it.

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