During 2007 and 2008 the global ?financial system experienced a severe crisis. Many banks in the USA and in Europe, some of them major players in the industry, either went bankrupt, were taken over, or were rescued by governments. By October 2008, the losses of the banking sector were estimated to have reached $1,000 billion in the USA, and the UK government took significant steps towards nationalization of the banks. In the meantime, the hedge fund industry suffered an incredible shrinkage. Its assets under management fell dramatically.

The number of hedge funds, which climbed to over 7,000 at the peak, is estimated to have fallen by half. The ?financial crisis had its origins in the subprime lending of the housing market, but rapidly spread to every other segment of the credit markets.

This paper presents a theoretical model that explains the crisis in light of the capital structure of modern fi?nancial institutions. Our model stresses two recent developments in the balance sheet of fi?nancial institutions: the increasingly reliance on leverage, and the changes that occurred in the structure of lenders, with large fi?nancial institutional investors occupying a greater role as debt holders. In the last two decades, a greater number of commercial banks have sourced ever greater amounts of funds in the wholesale money market, a market dominated by large institutional investors.

Similarly, hedge funds have a close relation with prime brokers at investment banks, which are their most important source of credit, as well as executioners of trades. Hedge funds experienced a very fast growth of assets under management since the previous ?financial bust of 2001 and 2002. The symbiotic relationship of large institutional investors is indeed a feature of the modern ?financial markets. Such tight interdependence of large players has both advantages and disadvantages.

The disadvantage that we explore in this paper is the following: when a large creditor of a ?financial institution suffers a shock, it is forced to delever and this results in a sudden withdrawal of credit from a borrower fi?nancial institution. In many instances, the mere suspicion that a large creditor is in trouble can trigger a panic by other lenders, who then desert the ?financial institution and force its rapid collapse. As Shin (2008) noted: ?The problems [of Northern Rock] stemmed from its high leverage couple with a reliance on institutional investors for short term funding?.

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