In modern economies, the government guarantees the debt of many borrowers. In a few cases, the promise is explicit; in others it is implicit but known to be likely; and in others, the guarantee occurs because the alternative is immediate collapse, with substantial harm to the rest of the economy. The modern government cannot stop itself from making good on the obligations of many borrowers, large and small. I demonstrate that debt guarantees deplete equity from fi rms at times of declines in asset values. Not only do fi rms fail to replace equity lost when leveraged portfolios lose value, but they have an incentive to deplete equity further, by paying unusually high dividends.
The government adopts a safeguard to protect the taxpayers against the worst abuses of guarantees|it imposes a capital requirement to limit the ratio of guaranteed debt to the value of the underlying collateral. In the United States, organizations with explicit guarantees on some debt (deposits) are mainly banks. The non-deposit obligations of banks and other intermediaries, notably the two huge mortgage-holders, Fannie Mae and Freddie Mac, enjoy market values that only make sense on the expectation of a government guarantee.
The removal of entry barriers in banking is one of the main aspects of the integration of financial markets that is taking place in many countries. In the European Union, the First and Second Banking Directives (1977, 1988), and recently the Financial Services Action Plan (1999) consisted of large sets of initiatives to ensure the full integration of European banking markets; also various deregulations at the national level have helped to foster banking integration.
Although most of the cross{border and cross{regional activities in Europe are taking place via mergers and acquisitions, there has been substantial de{novo entry in Portugal, Southern Italy, and in many of the Central and Eastern European accession countries (Barros (1995), Bonaccorsi di Patti and Gobbi (2001), Caviglia, Krause, and Thimann (2002)). In the United States, the removal of bank branch restrictions in the 1980s has led to significant entry by new banks and to improvements in the quality of loans (Jayaratne and Strahan (1996)), but also a greater number of bank failures (Keeley (1990)). However, the extent of de{novo entry in developed economies is regarded as quite limited, whereas developing economies (most notably Latin America and Eastern Europe) have attracted the most foreign bank entry (see Clarke, Cull, Martinez Peria, and Sanchez (2003)).
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.
