Optimal Financial Crises

Empirical evidence suggests that banking panics are a natural outgrowth of the business cycle. In other words panics are not simply the result of "sunspots" or self-fulfilling prophecies. Panics occur when depositors perceive that the returns on the bank's assets are going to be unusually low. In this paper we develop a simple model of this type of panic. In this setting bank runs can be incentive-efficient: they allow more efficient risk sharing between depositors who withdraw early and those who withdraw late and they allow banks to hold more efficient portfolios. Central bank intervention to eliminate panics can lower the welfare of depositors. However there is a role for the central bank to prevent costly liquidation of real assets by injecting money into the banking system during a panic.

Asset Price Bubbles and Stock Market Interlinkages

The eect of stock market interlinkages on asset price bubbles are considered. Bubbles can occur when there is an agency problem between banks and the people they lend money to because the banks cannot observe how the funds are invested. This causes a risk shifting problem and asset prices are bid up above their fundamental. The greater is uncertainty about asset returns or about the amount of aggregate credit the greater is the bubble. Stock market interlinkages can moderate or exacerbate asset price bubbles.

Diversity of Opinion and Financing of New Technologies

The objective is to compare the effectiveness of financial markets and financial intermediaries in financing new industries and technologies in the presence of diversity of opinion. In markets, investors become informed about the details of the new industry or technology and make their own investment decisions. In intermediaries, the investment decision is delegated to a manager. She is the only one who needs to become informed, which saves on information costs, but investors may anticipate disagreement with her and be unwilling to provide funds. Financial markets tend to be superior when there is significant diversity of opinion and information is inexpensive.Diversity of opinion; investment; financial markets; financial intermediaries; delegation; Bayesian decision making; uncommon priors

Diversity of Opinion and Financing of New Technologies

The objective is to compare the effectiveness of financial markets and financial intermediaries in financing new industries and technologies in the presence of diversity of opinion. In markets, investors become informed about the details of the new industry or technology and make their own investment decisions. In intermediaries, the investment decision is delegated to a manager. She is the only one who needs to become informed, which saves on information costs, but investors may anticipate disagreement with her and be unwilling to provide funds. Financial markets tend to be superior when there is significant diversity of opinion and information is inexpensive.

Financial Contagion

contagion; bank runs; banking; financial crisis

Asset Price Bubbles and Monetary Policy

Positive and negative asset price bubbles and their relationship to monetary policy are considered. Positive bubbles occur when there is an agency problem between banks and the people they lend money to because the banks cannot observe how the funds are invested. This causes a risk shifting problem and asset prices are bid up above their fundamental. The greater is uncertainty concerning monetary policy and the amount of aggregate credit the greater is the bubble. Negative bubbles can occur when there is a banking crisis that forces banks to simultaneously liquidate assets. Asset prices fall below their fundamental because of a lack of liquidity. If the central bank provides a monetary injection this negative bubble can be prevented.

Optimal Currency Crises

Flawed government policies have been offered as an explanation for currency crises in most of the previous literature. With few exceptions, the role of the banking system is ignored. Empirical evidence suggests that in recent decades banking crises and currency crises have been linked. A model is developed where the "twin" crises result from low asset returns. Large movements in exchange rates are desirable to the extent that they allow better risk sharing between a country's bank depositors and the international bond market. The rationale for using short-term debt denominated in a foreign reserve currency is also investigated.

Corporate Governance and Competition

The corporate governance systems operating in different countries are distinct. In the U.S. and U.K., it is often argued that the threat of takeover ensures managers act in the shareholders' interests. In countries such as Germany, Japan, and France, it is suggested banks and other institutions act as monitors. There is some evidence that neither system is particularly effective. We argue that competition among firms may be more effective than either of these mechanisms in ensuring that resources are used efficiently.

Financial Markets, Intermediaries and Intertemporal Smoothing

The return of assets that are traded on financial markets are more volatile than the returns offered by intermediaries such as banks and insurance companies. This suggests that individual investors are exposed to more risk in countries which rely heavily on financial markets. In the absence of a complete set of Arrow-Debreu securities, there may be a role for institutions that can smooth asset returns over time. In this paper, we consider one such mechanism. We present an example of an overlapping generations economy in which the incompleteness of financial markets leads to underinvestment in reserves. There exist allocations where by building up large reserves it is possible to smooth asset returns and eliminate non-diversifiable risk. This allows an ex ante Pareto improvement. We then argue that a long-lived intermediary may be able to implement this type of smoothing. However, the position of the intermediary is fragile; competition from financial markets can cause the intertemporal smoothing mechanism to unravel, in which case the intermediary will do no better than the market.