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Part 3 Fundamentals of Financial Institutions
Asymmetric Information and Financial Crises
We established in Chapter 7 that a fully functioning financial system is critical to a
robust economy. The financial system performs the essential function of channel-
ing funds to individuals or businesses with productive investment opportunities. If
capital goes to the wrong uses or does not flow at all, the economy will operate inef-
ficiently or go into an economic downturn.
Agency Theory and the Definition of a Financial Crisis
The analysis of how asymmetric information problems can generate adverse selec-
tion and moral hazard problems is called agency theory in the academic finance
literature. Agency theory provides the basis for defining a financial crisis. A finan-
cial crisis occurs when an increase in asymmetric information from a disruption in
the financial system prevents the financial system from channeling funds efficiently
from savers to households and firms with productive investment opportunities.
Dynamics of Financial Crises in Advanced Economies
Now that we understand what a financial crisis is, we can explore the dynamics of
financial crises in advanced economies such as the United States, that is, how these
financial crises unfold over time. As earth shaking and headline grabbing as the
most recent financial crisis was, it was only one of a number of financial crises in U.S.
history. These experiences have helped economists uncover insights on present-
day economic turmoil.
Financial crises in the United States have progressed in two and sometimes
three stages. To help you understand how these crises have unfolded, refer to
Figure 8.1, a diagram that traces out the stages and sequence of events in
advanced economies.
Stage One: Initiation of Financial Crisis
Financial crises can begin in several ways: mismanagement of financial liberaliza-
tion or innovation, asset price booms and busts, or a general increase in uncertainty
caused by failures of major financial institutions.
Mismanagement of Financial Liberalization or Innovation
The seeds of a
financial crisis are often sown when countries engage in financial liberalization,
the elimination of restrictions on financial markets and institutions, or the intro-
duction of new types of loans or other financial products. In the long run, finan-
cial liberalization promotes financial development and encourages a well-run
financial system that allocates capital efficiently. However, financial liberaliza-
tion has a dark side: in the short run, it can prompt financial institutions to go
on a lending spree, called a credit boom. Unfortunately, lenders may not have the
expertise, or the incentives, to manage risk appropriately in these new lines of
business. Even with proper management, credit booms eventually outstrip the abil-
ity of institutions—and government regulators—to screen and monitor credit risks,
leading to overly risky lending.
Chapter 8 Why Do Financial Crises Occur and Why Are They So Damaging to the Economy?
165
Increase in
Interest Rates
Increase in
Uncertainty
Asset Price
Decline
Unanticipated Decline
in Price Level
Banking
Crisis
Economic Activity
Declines
Economic Activity
Declines
Economic Activity
Declines
Consequences of Changes in Factors
Factors Causing Financial Crises
Adverse Selection and Moral
Hazard Problems Worsen
Adverse Selection and Moral
Hazard Problems Worsen
Adverse Selection and Moral
Hazard Problems Worsen
Deterioration in
Financial Institutions’
Balance Sheets
STAGE ONE
Initiation
of Financial
Crisis
STAGE TWO
Banking
Crisis
STAGE THREE
Debt
Deflation
F I G U R E 8 . 1
Sequence of Events in U.S. Financial Crises
The solid arrows in Stages One and Two trace the sequence of events in a typical financial crisis; the dotted arrows
show the additional set of events that occur if the crisis develops into a debt deflation, Stage Three in our discussion.
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Part 3 Fundamentals of Financial Institutions
Government safety nets such as deposit insurance weaken market discipline and
increase the moral hazard incentive for banks to take on greater risk than they
otherwise would. Since depositors know that government-guaranteed insurance pro-
tects them from losses, they will supply even undisciplined banks with funds. Banks
can make risky, high-interest loans, knowing that they’ll walk away with nice profits
if the loans are repaid, and leave the bill to the taxpayer if the loans go bad and the
bank goes under. Without proper monitoring, risk taking grows unchecked.
Eventually, this risk taking comes home to roost. Losses on loans begin to mount
and the drop in the value of the loans (on the asset side of the balance sheet) falls
relative to liabilities, thereby driving down the net worth (capital) of banks and other
financial institutions. With less capital, these financial institutions cut back on their
lending, a process called deleveraging. Furthermore, with less capital, banks and
other financial institutions become riskier, causing depositors and other potential
lenders to these institutions to pull out their funds. Fewer funds mean fewer loans
and a credit freeze. The lending boom turns into a lending crash.
When financial intermediaries’ balance sheets deteriorate and they deleverage
and cut back on their lending, no one else can step in to collect this information
and make these loans. The ability of the financial system to cope with the asymmetric
information problems of adverse selection and moral hazard is therefore severely
hampered (as shown in the arrow pointing from the first factor, Deterioration in
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