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Financial Institutions, Financial Contagion, and Financial Crises

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.

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Paper provided by Chicago - Graduate School of Business in its series Papers with number 21.

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Length: 39 pages
Date of creation: 2000
Date of revision:
Handle: RePEc:fth:chicbu:21
Contact details of provider: Postal: UNIVERSITY OF CHICAGO, H.G.B. ALEXANDER FOUNDATION GRADUATE SCHOOL OF BUSINESS, CHICAGO ILLINOIS 60637 U.S.A.
Web page: http://gsb.uchicago.edu/

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  1. Roberto Chang & Andres Velasco, 1998. "Financial Fragility and the Exchange Rate Regime," NBER Working Papers 6469, National Bureau of Economic Research, Inc.
  2. Charles A. E. Goodhart & Haizhou Huang, 1999. "A model of the lender of last resort," Proceedings, Federal Reserve Bank of San Francisco.
  3. Douglas W. Diamond & Raghuram G. Rajan, 1999. "Liquidity Risk, Liquidity Creation and Financial Fragility: A Theory of Banking," NBER Working Papers 7430, National Bureau of Economic Research, Inc.
  4. Xavier Freixas, 1999. "Optimal Bail Out Policy, Conditionality and Creative Ambiguity," FMG Discussion Papers dp327, Financial Markets Group.
  5. Shleifer, Andrei & Vishny, Robert W, 1992. " Liquidation Values and Debt Capacity: A Market Equilibrium Approach," Journal of Finance, American Finance Association, vol. 47(4), pages 1343-66, September.
  6. Chang, R. & Velasco, A., 1998. "Financial Crises in Emerging Markets: A Canonical Model," Working Papers 98-21, C.V. Starr Center for Applied Economics, New York University.
  7. Bee Yan Aw & Sukkyun Chung & Mark J. Roberts, 1998. "Productivity and the Decision to Export: Micro Evidence from Taiwan and South Korea," NBER Working Papers 6558, National Bureau of Economic Research, Inc.
  8. Corsetti, G. & Pesenti, P. & Roubini, N., 1998. "What Caused the Asian Currency and Financial Crisis?," Papers 343, Banca Italia - Servizio di Studi.
  9. Mathias Dewatripont & Eric Maskin, 1995. "Credit and efficiency in centralized and decentralized economies," ULB Institutional Repository 2013/9603, ULB -- Universite Libre de Bruxelles.
  10. Akerlof, George A, 1970. "The Market for 'Lemons': Quality Uncertainty and the Market Mechanism," The Quarterly Journal of Economics, MIT Press, vol. 84(3), pages 488-500, August.
  11. Franklin Allen & Douglas Gale, 1998. "Financial Contagion Journal of Political Economy," Center for Financial Institutions Working Papers 98-31, Wharton School Center for Financial Institutions, University of Pennsylvania.
  12. Rochet, Jean-Charles & Tirole, Jean, 1996. "Interbank Lending and Systemic Risk," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 28(4), pages 733-62, November.
  13. Oliver Hart & John Moore, 1994. "Debt and Seniority: An Analysis of the Role of Hard Claims in Constraining Management," NBER Working Papers 4886, National Bureau of Economic Research, Inc.
  14. Franklin Allen & Douglas Gale, 1998. "Optimal Financial Crises," Journal of Finance, American Finance Association, vol. 53(4), pages 1245-1284, 08.
  15. Steven Radelet & Jeffrey D. Sachs, 1998. "The East Asian Financial Crisis: Diagnosis, Remedies, Prospects," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(1), pages 1-90.
  16. Bolton, Patrick & Scharfstein, David S, 1996. "Optimal Debt Structure and the Number of Creditors," Journal of Political Economy, University of Chicago Press, vol. 104(1), pages 1-25, February.
  17. Roberto Chang & Andres Velasco, 1998. "Financial Crises in Emerging Markets," NBER Working Papers 6606, National Bureau of Economic Research, Inc.
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