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Economic Vulnerability and Financial Fragility

Unfortunately, many families with the greatest exposure to the economic dislocations of the recent recession also had very risky balance sheets beforehand that were characterized by low levels of liquid assets, high portfolio concentrations in housing, and relatively high balance-sheet leverage. The authors argue that economic vulnerability and risky balance sheets are correlated because they derive from common factors. These factors include a low stock of human capital, inexperience (relative youth), and, in some cases, the legacy of discrimination in housing, education, and employment. Innate cognitive ability interacts with formal education and on-the-job experience to build human capital, while the legacy of discrimination may attenuate the translation of cognitive ability and education into human capital. Acquiring financial knowledge of risk management also requires time and experience and is more valuable to those with high levels of human capital and savings available to invest. Given the combination of these factors, individuals and families who are young, less cognitively able, and/or members of historically disadvantaged minorities are more likely to be economically vulnerable and to hold risky balance sheets because they lack financial knowledge and experience. Moreover, balance sheets of economically vulnerable families before the recent recession were especially risky after a decade of financial liberalization and innovation that increased the access of such families to homeownership and historically high leverage. Economically vulnerable families should avoid “doubling down” with risky balance sheets to enhance their future household financial stability.

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