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Understanding Financial Crises

Understanding Financial Crises. Franklin Allen and Douglas Gale Clarendon Lectures in Finance June 9-11, 2003. Lecture 1. Banking Crises Franklin Allen University of Pennsylvania June 9, 2003 http://finance.wharton.upenn.edu/~allenf/. Introduction. What happened in Asia in 1997?

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Understanding Financial Crises

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  1. Understanding Financial Crises Franklin Allen and Douglas Gale Clarendon Lectures in Finance June 9-11, 2003

  2. Lecture 1 Banking Crises Franklin Allen University of Pennsylvania June 9, 2003 http://finance.wharton.upenn.edu/~allenf/

  3. Introduction • What happened in Asia in 1997? • Conventional wisdom about causes • Inadequate corporate governance • Lack of transparency • Poor regulatory supervision • Guarantees by governments and IMF

  4. But • If these are the explanations why didn’t these crises occur before? • All of these factors were present while the economies were growing at fast rates for many years • Crises occur in many situations where these factors are not present • It is necessary to take a broad perspective

  5. Banking and Currency Crises in the 19th and Early 20th Centuries • Europe: Crises eliminated by central banks in the last half of the 19th century • Bank of England: Overend and Gurney crisis in 1866 and Bagehot (1873) • US: Crises endemic in the last half of the 19th and early 20th centuries: • Sep 1873, Jun 1884, Nov 1890, May 1893, Oct 1896, Oct 1907, Aug 1914

  6. How do recent crises compare with previous crises? Bordo and Eichengreen (2000): Gold Standard Era 1880-1913 Interwar Years 1919-1939 Bretton Woods Period 1945-1971 Recent Period 1973-1998

  7. Bordo and Eichengreen’s (2000) Results • Banking, currency and twin crises have occurred under many different regimes • Recessions with crises are more severe than those without them • Special features of 1880-1913, 1919-1938, 1945-1971 and 1973-1998

  8. Issues • Why do crises occur unless actively prevented by central banks and governments? • What policies, if any, are required to prevent crises?

  9. Banking Crises: Two Theories 1. Crises as Financial Panics • Kindleberger (1978), Diamond and Dybvig (1983) • Multiple equilibria 2. Fundamental based crises • Gorton (1988), Allen and Gale (1998) • Essential equilibria

  10. Crises as Financial Panics Diamond and Dybvig (1983) model: DD • Single good and two riskless assets Date 0 1 2 Short asset y 1 1 1 Long asset x 1 R>1 Liquidate r<1

  11. Consumers Date 0 1 2 2 ex ante 1 Early 1 Late identical c1 c2 EU=u(c1)+u(c2) Endowment 1 • Banks are competitive: • Maximize EU of depositors

  12. Bank’s problem • Max EU = u(c1) + u(c2) y,x,c1,c2 subject to y + x ≤ 2 c1 ≤ y c2 ≤ Rx + y – c1 c1 ≤ c2

  13. Optimal solution c1 = y c2 = Rx u’(c1)/u’(c2) = R c1 < c2 since u’’ < 0

  14. DD: Two “equilibria” at date 1 • Good equilibrium implements optimum • Early consumers withdraw at date 1 • Late consumers stay until date 2 • Bad equilibrium • All withdraw at date 1 and c1=c2=(y+rx)/2 • Equilibrium selection • Sunspots • Lack of common knowledge – Morris and Shin (1998)

  15. Policy implications • Focus of policy is to rule out the bad equilibrium • DD suggest that deposit insurance does this at no cost

  16. Fundamental Based Crises • Gorton (1988) found 19th Century US crises are predictable • Whenever the leading economic indicator represented by the liabilities of failed businesses reached a particular threshold a crisis occurred

  17. Allen and Gale (1998) adapt DD model Short riskless asset and risky long asset Date 0 1 2 Safe asset y 1 1 1 Risky asset x 1 R>1 R learned Now c1(R) and c2(R) but otherwise similar to before

  18. Optimal allocation Benchmark result: Banking crises allow the optimal allocation to be implemented even though deposit contracts are used

  19. Allen and Gale (2003) show that this result holds in a much more general model • With real shocks, optimal risk sharing requires contingencies and, given the debt-like properties of demand deposits, crises are the only way to achieve these contingencies

  20. Costly crises • If banks have superior reinvestment possibilities from date 1 to date 2 of ρ > 1 while individuals can only use the storage technology the optimal allocation can be implemented if • Contracts are nominal • The central bank provides money to banks • Resources stay inside the banking system

  21. Optimal allocation Risk sharing occurs through variations in the price level

  22. Conclusions • Banking crises can be • Financial panics OR • Fundamental based • Financial panics can be eliminated with deposit insurance • Fundamental based crises eliminated by a central bank acting as lender of last resort

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