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Financial Institutions, Financial Contagion, and Financial Crises

Author

Listed:
  • Haizhou Huang
  • Chenggang Xu

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.

Suggested Citation

  • Haizhou Huang & Chenggang Xu, 1999. "Financial Institutions, Financial Contagion, and Financial Crises," CID Working Papers 21A, Center for International Development at Harvard University.
    • Handle: RePEc:cid:wpfacu:21a
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    File URL: https://www.hks.harvard.edu/sites/default/files/centers/cid/files/publications/faculty-working-papers/021.pdf
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    Citations

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    Cited by:

    1. Veysov, Alexander & Stolbov, Mikhail, 2011. "The impact of financial sector on innovation activity: theoretical background and new evidence from russian banking sector," MPRA Paper 38747, University Library of Munich, Germany.
    2. Katharina PISTOR, 2000. "The Standardization Of Law And Its Effect On Developing Economies," G-24 Discussion Papers 4, United Nations Conference on Trade and Development.
    3. Rodica Sandu-Loisel, 2007. "Hardened Budget Constraints in Romania: An Approach by CGE Modeling," Post-Communist Economies, Taylor & Francis Journals, vol. 19(1), pages 93-115.
    4. Jiahua Che, 2000. "Decentralized Financing, Centralized Financing and the Dual Track System: Toward a New Theory of Soft Budget Constraints," William Davidson Institute Working Papers Series 261, William Davidson Institute at the University of Michigan.
    5. Nan-Kuang Chen & Hsiao-Lei Chu, 2003. "Collateral Value and Forbearance Lending," CEP Discussion Papers dp0603, Centre for Economic Performance, LSE.
    6. Xu, Cheng-Gang & Maskin, Eric, 2001. "Soft Budget Constraint Theories: From Centralization to the Market," CEPR Discussion Papers 2715, C.E.P.R. Discussion Papers.
    7. Mehrdad Vahabi, 2021. "Introduction: a special issue in honoring Janos Kornai," Public Choice, Springer, vol. 187(1), pages 1-13, April.

    More about this item

    Keywords

    financial institutions; corporate finance; bank run; financial contagion; financial crisis;
    All these keywords.

    JEL classification:

    • D2 - Microeconomics - - Production and Organizations
    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • G2 - Financial Economics - - Financial Institutions and Services
    • G3 - Financial Economics - - Corporate Finance and Governance
    • P5 - Political Economy and Comparative Economic Systems - - Comparative Economic Systems

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