Financial Institutions, Financial Contagion, and Financial Crises

Haizhou Huang () and Chenggang Xu

CID Working Papers from Center for International Development at Harvard University

Abstract: 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 in-formation 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.

Keywords: Financial Institutions; Corporate Finance; Bank Run; Financial Contaigion; Financial Crisis (search for similar items in EconPapers)
JEL-codes: D2 D8 E58 G2 G3 P5 (search for similar items in EconPapers)
Date: Written 1999-07
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Related works:
Working Paper: Financial Institutions, Financial Contagion, and Financial Crises (2000)
Working Paper: Financial Institutions, Financial Contagion, and Financial Crises (2000)
Working Paper: Financial Institutions, Financial Contagion, and Financial Crises (2000)
Working Paper: Financial Institutions, Financial Contagion, and Financial Crises (2000)
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Persistent link: http://EconPapers.repec.org/RePEc:wop:cidhav:21

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