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Financial Institutions, Financial Contagion, and Financial Crises

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Financial Institutions,Financial Contagion,and Financial CrisesHaizhou Huang and Chenggang XuCID Working Paper No. 21July 1999© Copyright 1999 Haizhou Huang, Chenggang Xu,and the President and Fellows of Harvard CollegeWorking PapersCenter for International Developmentat Harvard UniversityCID Working Paper no. 21Financial Institutions, Financial Contagion, and Financial CrisesHaizhou Huang and Chenggang Xu*AbstractThis paper endogenizes financial contagion and financial crises from financial institutions. Weshow that financial crises can emanate from financial institutions which generate soft-budgetconstraints (SBC). The prevailing SBC in an economy distort in-formation such that theinterbank lending market faces a “lemon” problem. The lemon problem in the lending marketmay contribute to bank-run contagions and can lead to the collapse of the lending market whileinducing a run on the economy. Moreover, due to the lemon problem in the financial system, arational government policy in this economy will lead to a SBC trap that all the illiquid banks areto be bailed out. In comparison, we show that an economy with a predominance of diversifiedfinancial institutions will be featured by hard-budget constraints. From this point, we showmechanisms that in this economy firms disclose timely information to the banks and to thefinancial market as a whole. Thus bank runs can be stopped, contagious risks contained andfinancial crisis prevented.JEL Codes: D2, D8, E58, G2, G3, P5Keywords: Financial Institutions, Corporate Finance, Bank Run, Financial Contaigion, FinancialCrisisHaizhou Huang is an economist in the Monetary and Exchange Affairs Department of theInternational Monetary Fund. Email: [email protected] Xu is a Faculty Research Fellow of CID, a Faculty Associate at HIID, and a lecturerof economics at London School of Economics. Email: [email protected]* We are indebted to Eric Maskin for his important suggestions and advice. We are also grateful to WilliamAlexander, Abhijit Banerjee, Tito Cordella, Charles Goodhart, Nobu Kiyotaki, Janos Kornai, John Moore, DwightPerkins, Jean-Charles Rochet, and Jean Tirole for helpful comments; to the seminar and conference participants atAEA, EEA, HIID, IMF, LSE, Southampton, and Toulouse; and to Natalie Baumer for editorial assistance.ILQDQFLDO LQVWLWXWLRQV/ ILQDQFLDO FRQWD JLRQ/DQG ILQDQFLDO FULVLVKdl}krx Kxdqj dqg Fkhqjjdqj [xLQWU RGXFWLRQWkh qdqfldo fulvlv lq Hdvw Dvld suhvhqwv juhdw fkdoohqjhv wr hfrqrplvwv1 Ehiruh wkh fulvlv/wkh Hdvw Dvldq hfrqrplhv kdg ehhq grlqj y hu| zhoo  hfrqrplhv kdg kljk jur zwk udwhv/ kljkvdylqjv udwhv/ dqg vrxqg vfdo srolflhv1 Lq dgglwlrq wr h{rjhqrxv vkrfnv zklfk pd| kdy hfrqwulexwhg wr wkh ryhudoo sureohp/ wkh txhvwlrq uhpdlqv zkhwkhu wkhuh duh ixqgdphqwdosureohpv zlwklq wkh uhvshfwlyh Dvldq hfrqrplhv zklf k surylgh frqglwlrqv iru wkh fulvlvBWklv sdshu dwwhpswv wr dqdo|}h wkh qdqfldo lqvwlwxwlrqdo sureohpv/ wr xqghuvwdqg krzwkrvh sureohpv pd| kdyh uhvxowhg lq qdqfldo fulvhv1 Iroorzlqj duh vrph ri wkh pruh srsxoduh{sodqdwlrqv iru wkh Dvldq fulvlv= wkh uxq e| sdqlfnhg lqy hvwruv rq wkh hfrqrplhv/ vlploduwr wkh uxq e| sdqlfnhg ghsrvlwruv rq d edqn +Udghohw dqg Vdfkv/ 4<<;> Vwljolw}/ 4<<;,> wkhprudo kd}dug lq edqnlqj +Nuxjpdq/ 4<<;> Dnhuori dqg Urphu/ 4<<7,> dqg wkh froodsvh ri dexeeoh hfrqrp| +Hglvrq hw do1/ 4<<;> Eodqfkdug dqg Zdwvrq/ 4<;5,1 Wkhvh dujxphqwv duhxvhixo wr lghqwli| srwhqwldo sureohpv> qhyhuwkhohvv/ wkhlu dujxphqwv pd| udlvh pdq| pruhtxhvwlrqv wr eh vwxglhg1Zh vwxg| jhqhudwlrq dqg wudqvplvvlrq phfkdqlvp ri edqn uxq frqwdjlrq lq qdqfldolqvwlwxwlrqv zlwk xqvhfxuhg ghewv1 H{dpsohv ri xqvhfxuhg ghewv duh edqnv ghsrvlwv/ qrq0froodwhudol}hg ru qrq0lqvxuhg ordqv/ ru ordqv cjxdudqwhhg* rqo| e| uhsxwdwlrqv zklfk pd|qrw eh fuhgleoh zkhq wkhuh duh judy h oltxlglw| vkrfnv1 Rxu wkhru| lv frpsohphq wdu| wrNl|rwdnl dqg Prruh +4<<:, zklfk vwxglhv krz fuhglw frqvwudlqwv lqwhudfw zlwk dvvhw sulfhvzkhq ghewv duh vhfxuhg e| froodwhudo dvvhwv1 Wkh| vwxg| krz wkdw lqwhudfwlrq vhuyhv dv dwudqvplvvlrq phf kdqlvp wkurxjk zklfk whpsrudu| vkrfnv fdq jhqhudwh odujh dqg shuvlvwhq w xfwxdw l rq v lq rxwsxw v14Lw kdv ehhq revhuyhg wkdw wkh qdqfldo fulvlv lq Dvld ixqgdphqwdoo| uhvxowhg iurp wkhlqdelolw| ri wkhlu qdqfldo lqvwlwxwlrqv wr sxw d kdow wr ordqv wr edg surmhfwv h{ srvw1 Wkdwlv wkh qdqfldo lqvwlwxwlrqv surylgh vriw0exgjhw frqvwudlq wv +VEF, rq upv/ vlplodu wr zkdwNruqdl revhuyhg rq vwdwh hqwhusulvhv lq fhq wudol}hg hfrqrplhv +4<;3/ 4<;9,1 Zh ghwhuplqhiurp wkh vriw exgjhw v|qgurph wkdw lw dhfwv qrw rqo| wkh h!flhqflhv ri d qdqfldo pdun hw/exw pruh lpsruwdqw/ lw glvwruwv wkh pdunhw*v lqirupdwlrq vr wkdw wkh lqwhuedqn ohqglqjpdunhw lv frqiurqwhg zlwk d ohprq sureohp1 Wkh dydlodelolw| ri lqirupdwlrq derxw edqntxdolw| lv fulwlfdo iru wkh rshudwlrq ri wkh qdqfldo pdunhw lq surylglqj ordqv wr looltxlgedqnv1 Wklv ohprq sureohp lq wkh qdqfldo pdunhw pd| frq wulexwh wr edqn uxq frqwdjlrqwkdw fdq ohdg wr wkh froodsvh ri lqwhuedqn ohqglqj p dun hwv dqg lqgxfh doo lq yhvwruv wr sdqlf/wkxv d uxq rq wkh hfrqrp|14Lq frpsdulvrq/ dq hfrqrp| zlwk d suhgrplqdqfh ri glyhuvlhg qdqfldo lqvwlwxwlrqv zlooeh ihdwxuhg e| kdug0exgjhw frqvwudlqwv +KEF, rq upv +zlwk d frpplwphq w wr vwrs edgsurmhfwv h{ srvw,1 Zh ghwhuplqh wkdw dq KEF hfrqrp| zloo glvforvh wlpho| exvlqhvv0uhodwhg lqirupdwlrq iurp wkh upv wr wkh edqnv/ dqg wr wkh qdqfldo pdun hw1 Wkxv lq dqKEF hfrqrp |/ edqn uxqv fdq eh vwrsshg/ frqwdjlrxv ulvnv frqwdlqhg dqg qdqfldo fulvlvsuhyhq whg1Lq rxu prgho wkhuh duh pdq| edqnv zklfk uhfhly h ghsrvlwv dqg lqy hvw lqwr surmhfwv1 Edqnvuho| rq lqwhuedqn ohqglqj pdunhw wr hdvh oltxlglw| vkruwdjh sureohp zkhq wkh| idfh oltxlglw|vkrfnv1 Dowkrxjk wr irfxv rq rxu pdlq srlqwv zh gr qrw hqgrjhql}h wkh qxpehu ri edqnv/kdylqj pdq| ghfhqwudol}hg edqnv lq wkh hfrqrp | lv qhfhvvdu| iru wkh iroor zlqj uhdvrqv1Iluvw/ lq rxu wkhru| d ghfhq wudol}hg qdqfldo v|vwhp zlwk pdq| edqnv lv d ghylfh wr vroy hfrpplwphqw sureohp dqg wr uhgxfh frqwdjlrxv ulvnv1 Vhfrqg/ frpshwlwlrq dprqj edqnv lvlpsruwdqw iru h!flhqw doorfdwlrq ri qdqfldo uhvrxufhv lq rxu prgho1Wr eh vshflf/ lq rxu prgho wkhuh duh qxphurxv ghsrvlwruv ri wkh w|sh ghvfulehg e|Gldprqg0G|eylj +Gldprqg dqg G|eylj/ 4<;6,/ zkr duh glylghg lqwr hduo| frqvxphuv +zkr4Wr irxfxv rq rxu srlqw zh grqrw p rgho shhu prqlwrulqj lq wkh lqwhuedqn ohqglqj lq wkh vhqvh ri Urfkhwdqg Wluroh +4<<9,1 Lq idfw/ dv orqj dv shhu prqlwrulqj lv pxfk


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