Fragility of Reputation and Clustering in Risk Taking

I study the interplay between reputation and risk-taking in a dynamic stochastic environment where it is ex-ante efficient for firms to engage in safe projects, but ex-post preferred to invest in risky ones, appropriating surplus from lenders. By introducing fundamentals, I interpret the model as a dynamic global game in which strategic complementarities arise endogenously from reputation updating, overcoming pervasive multiple equilibria. I find that even though reputation deters opportunistic behavior, it introduces fragile incentives which may lead to large changes in aggregate risk-taking in response to small changes in aggregate fundamentals, inducing financial crises and credit crunches.