It has been documented that financial crises often accompany problems in financial institutions, probably even more so at some specific stages of development. The recent financial crisis in East Asia, and the major financial crises in Europe and America in the late 1920s and earlier, provide examples. This paper develops a theory which endogenizes financial crises through institutions related to the corporate sector, banks, and the interbank market. The basic idea is that different ways of financing corporate investment projects may affect the nature of bankruptcy in failing projects. This in turn affects information in the interbank market. For financial institutions unable to commit to liquidate bad projects, there will be informational problems between entrepreneurs and banks, which will cause informational problems among banks in the interbank market. Severe informational problems in the interbank market can lead to a market failure, which constitutes a mechanism for financial contagion and creates conditions for a financial crisis.
Our theory emphasizes the role of financial institutions in explaining financial crises, in particular the 1997 East Asian financial crisis. Immediately before the crisis, the East Asian economies had been doing so well that there was a major debate among economists concerning the nature of the “miracle.” The eruption of the financial crisis in East Asia presents a major challenge to economists and policy makers. A particularly puzzling phenomenon regarding the crisis is derived from a comparison between Korea and Taiwan. Korea and Taiwan were both regarded as the major phenomenon of the so-called “East Asia Miracle.” However, while Korea was at the center of the East Asian crisis, Taiwan was much less affected — even though it too had been attacked by international speculators.
Was this difference an accident? Our analysis of the functions of corporate and banking institutions will provide an answer to this puzzling phenomenon. Consistent with observations that the financial crisis in East Asia was deeply linked to corporate financial problems, our theory suggests that different financing structures in the various East Asian economies generated a profound impact on the information in their respective financial markets, which further affected financial stability.
Our theory can be summarized as follows. Informational structures in two different kind of economies are endogenized. In an economy where corporations are financed by multiple banks or through a syndicated loan, the liquidation of bad projects/firms is a norm in the economy (see the model). The liquidation of bad projects makes information public so that banks have more knowledge about each another’s assets and solvency. In the remainder of the paper, we term this kind of economy a multi bank-finance (MBF) economy.
In an economy where financing decisions of corporations are concentrated (e.g., the Japanese main-bank system or the Korean principal-transaction-bank system), however, the liquidation of bad projects/firms is an exception (see the model). Without the liquidation of bad projects, banks with bad projects can easily hide bad news from others. We show that in such an economy bad projects are not liquidated and thus the solvency of a financier is not known to other financiers. In the remainder of the paper, we call this kind of economy a single-bank-finance economy (SBF).
In our model, an economy has many banks which receive deposits (à la Diamond and Dybvig, 1983) and invest in long-term projects with stochastic returns. Moreover, there is an interbank market which may solve liquidity shortage problems among banks. That is, when a bank faces a liquidity shock it may borrow from others in the market. The function of the interbank market depends on information about the asset quality of the borrowing bank. When an equilibrium is such that bad projects are liquidated (e.g., in MBF economy), which can be observed by other banks, the interbank market can function well and trading among banks can solve the liquidity problem faced by illiquid banks.
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