Financial institutions, financial contagion, and financial crises

Abstract

In this paper financial contagion and crises are endogenized through the interactions among corporations, banks and the interbank market. We show that the lack of financial disciplines in a single-bank-financing economy generates informational problems and thus the malfunction of the interbank market, which constitutes a mechanism of financial contagion and may lead to a financial crisis. In contrast, financial disciplines in an economy with diversified financial institutions lead to timely information disclosure from firms to banks and improve the informational environment of the interbank market. With symmetric information in the interbank market, bank runs are contained to insolvent banks and financial crises are prevented. Our theory sheds light to the causes and timing of the East Asian crisis, it also has important policy implications on lender of last resort and banking reform.