How the Western banking system came close to total collapse is not hard to explain. Tight credit conditions turned into full-blown financial panic when Lehman Brothers, the US investment bank, failed in September 2008. Banks suddenly ceased to have access to funding because the interbank lending market froze up. It required governments to rescue the banking system with huge sums of taxpayers’ money. Why this happened is less clear. My thesis is that there were incentives throughout the financial system for various actors to behave rationally by their own lights but with terrible consequences for financial stability.

It is worth first recounting the mechanics of the crisis, because there is a danger of focusing too much on Lehman’s. When Lehman’s collapsed, the reasoning behind the decision to let it fail was far from obviously misguided. It was a calculated risk. The notion that every bank was so inextricably linked with every other bank that it needed to b...