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Financial Institutions, Financial Contagion, and Financial Crises

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  • Haizhou Huang
  • Chenggang Xu

Abstract

Financial crises are endogenized through corporate and interbank market institutions. Financial crises can emanate from financial institutions which determine the nature of equilibrium in the interbank market. Single-bank financing leads to a pooling equilibrium whereby all illiquid banks are treated in the same manner in the interbank market. With private information about one's own solvency, the best illiquid banks will not borrow but rather will liquidate some premature assets. The withdrawals of the best banks from the interbank market will generate negative externalities in the market. Consequently, the quality of the interbank market will decline - which will make the more solvent but illiquid banks withdraw from the market - and thus the quality of the market will be further deteriorated and more banks will withdraw from the market, until interbank market collapses. However, multi-bank financing leads to a separating equilibrium whereby solvent and insolvent banks are distinguishable in the interbank market. As a result, bank runs are limited to illiquid and insolvent banks, and idiosyncratic shocks never trigger a bank run contagion.

Suggested Citation

  • Haizhou Huang & Chenggang Xu, 2000. "Financial Institutions, Financial Contagion, and Financial Crises," William Davidson Institute Working Papers Series 316, William Davidson Institute at the University of Michigan.
  • Handle: RePEc:wdi:papers:2000-316
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    Cited by:

    1. Goodhart, Charles A.E. & Huang, Haizhou, 2005. "The lender of last resort," Journal of Banking & Finance, Elsevier, vol. 29(5), pages 1059-1082, May.
    2. 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.
    3. 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.
    4. Coudert, Virginie & Gex, Mathieu, 2010. "Contagion inside the credit default swaps market: The case of the GM and Ford crisis in 2005," Journal of International Financial Markets, Institutions and Money, Elsevier, vol. 20(2), pages 109-134, April.
    5. 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.
    6. Eric Maskin & Chenggang Xu, 2001. "Soft budget constraint theories: From centralization to the market," The Economics of Transition, The European Bank for Reconstruction and Development, vol. 9(1), pages 1-27, March.
    7. Elías Albagli, 2003. "El Embriague Financiero: Una Visión Alternativa de Amplificación Bancaria," Working Papers Central Bank of Chile 207, Central Bank of Chile.
    8. Xavier Freixas & Anthony M. Santomero, 2002. "An overall perspective on banking regulation," Working Papers 02-1, Federal Reserve Bank of Philadelphia.
    9. Julien Reynaud & Rofikoh Rokhim, 2005. "Do banking crises enhance efficiency ? A case study of 1994 Turkish and 1997 Indonesian crises," Cahiers de la Maison des Sciences Economiques bla05007, Université Panthéon-Sorbonne (Paris 1).
    10. Emilio Colombo & Akos Valentinyi, 2002. "Subsidies, Soft Budget Constraints and Financial Market Imperfections," Working Papers 50, University of Milano-Bicocca, Department of Economics, revised Feb 2002.
    11. Peter B. Clark & Haizhou Huang, 2001. "International Financial Contagion and the IMF; A Theoretical Framework," IMF Working Papers 01/137, International Monetary Fund.
    12. Peter Clark & Haizhou Huang, 2006. "International Financial Contagion and the Fund —A Theoretical Framework," Open Economies Review, Springer, vol. 17(4), pages 399-422, December.
    13. Caramazza, Francesco & Ricci, Luca & Salgado, Ranil, 2004. "International financial contagion in currency crises," Journal of International Money and Finance, Elsevier, vol. 23(1), pages 51-70, February.
    14. Raphael H. Solomon, 2004. "When Bad Things Happen to Good Banks: Contagious Bank Runs and Currency Crises," Staff Working Papers 04-18, Bank of Canada.
    15. Nan-Kuang Chen & Hsiao-Lei Chu, 2003. "Collateral Value and Forbearance Lending," CEP Discussion Papers dp0603, Centre for Economic Performance, LSE.
    16. Raphael H. Solomon, 2005. "Pocket Banks and Out-of-Pocket Losses: Links between Corruption and Contagion," Staff Working Papers 05-23, Bank of Canada.
    17. Eric Santor, 2003. "Banking Crises and Contagion: Empirical Evidence," Staff Working Papers 03-1, Bank of Canada.

    More about this item

    JEL classification:

    • D20 - Microeconomics - - Production and Organizations - - - General
    • D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • G20 - Financial Economics - - Financial Institutions and Services - - - General
    • G30 - Financial Economics - - Corporate Finance and Governance - - - General
    • P50 - Economic Systems - - Comparative Economic Systems - - - General

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