Financial Institutions, Financial Contagion, and Financial Crises
International Conference on Transition Economics Working Paper No. F11
Posted: 12 Oct 1999
Date Written: July 1999
This paper endogenizes financial contagion and financial crises from financial institutions. We show that financial crises can emanate from financial institutions which generate soft-budget constraints (SBC). The prevailing SBC in an economy distort information such that the interbank lending market faces a "lemon" problem. The lemon problem in the lending market may contribute to bank-run contagions and can lead to the collapse of the lending market while inducing a run on the economy. Moreover, due to the lemon problem in the financial system, a rational government policy in this economy will lead to a SBC trap that all the illiquid banks are to be bailed out. In comparison, we show that an economy with a predominance of diversified financial institutions will be featured by hard-budget constraints. From this point, we show mechanisms that in this economy firms disclose timely information to the banks and to the financial market as a whole. Thus bank runs can be stopped, contagious risks contained and financial crisis prevented.
JEL Classification: F33, F41, F42, O16
Suggested Citation: Suggested Citation