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Financial Institutions, Financial Contagion, and Financial Crises

 
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Author
Huang, Haizhou
Xu, Chenggang
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https://www.hks.harvard.edu/centers/cid/publications
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Citation
Huang, Haizhou, and Chenggang Xu. “Financial Institutions, Financial Contagion, and Financial Crises.” CID Working Paper Series 1999.21, Harvard University, Cambridge, MA, July 1999.
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.
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This article is made available under the terms and conditions applicable to Other Posted Material, as set forth at http://nrs.harvard.edu/urn-3:HUL.InstRepos:dash.current.terms-of-use#LAA
Citable link to this page
http://nrs.harvard.edu/urn-3:HUL.InstRepos:39402526

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