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Potential and Possible Consequences of Systemic Financial Crisis

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The paper now outlines the principal theoretical approaches to the financial crisis. The first two sections cover, respectively, the concept of contagious runs on financial institutions and markets, and the aspects of financial regulation, which seek to protect against such events. I then assess two ‘traditional’ views of the financial crisis, which attempt to explain exclusively the totality of financial crises, namely the financial fragility and monetarist approaches. These are followed by more recent paradigms, which seek to clarify the mechanisms involved in crises, namely uncertainty, credit rationing, asymmetric information/agency costs, and aspects of the dynamics of dealership markets. It is important, to begin with, an argument of contagious runs since they are the principal identifying factor for crises. Of all the types of risks to banks, the focus here is on liquidity risk, which is the inability to obtain funding to finance operations, though it may be linked to interest-rate and credit risk. Although most of the analysis covers banks, these concepts can also be applied to other financial institutions and even securities markets. Any event, however extraneous, but including runs on or insolvency of other banks can according to Diamond and Dybvig (1983), provoke such runs. Such an effect might be particularly potent for banks, which are creditors of the bank in distress. Runs are also likely when the equity of banks is a small proportion of balance-sheet totals, as depositors’ fears of moral hazard increase, assuming managers’ actions cannot be perfectly monitored (L. J. White 1989). And, more generally, in the presence of asymmetric information, which arises from banks’ creation of non-marketable assets, runs may be triggered by any event that makes depositors change their beliefs about banks’ riskiness.