Understanding Financial Crises

by Allen, Franklin; Gale, Douglas

• ISBN13: 9780199251414
• ISBN10: 019925141X
• Format: Hardcover
• Copyright: 2007-05-17
• Publisher: Oxford University Press

Summary

What causes a financial crisis? Can financial crises be anticipated or even avoided? What can be done to lessen their impact? Should governments and international institutions intervene? Or should financial crises be left to run their course? In the aftermath of the recent Asian financialcrisis, many blamed international institutions, corruption, governments, and flawed macro and microeconomic policies not only for causing the crisis but also unnecessarily lengthening and deepening it.Based on ten years of research, the authors develop a theoretical approach to analyzing financial crises. Beginning with a review of the history of financial crises and providing readers with the basic economic tools needed to understand the literature, the authors construct a series of increasinglysophisticated models. Throughout, the authors guide the reader through the existing theoretical and empirical literature while also building on their own theoretical approach. The text presents the modern theory of intermediation, introduces asset markets and the causes of asset price volatility,and discusses the interaction of banks and markets. The book also deals with more specialized topics, including optimal financial regulation, bubbles, and financial contagion.

Author Biography

Franklin Allen is the Nippon Life Professor of Finance and Professor of Economics at the Wharton School of the University of Pennsylvania. He has been on the faculty since 1980. He is currently Co-Director of the Wharton Financial Institutions Center. He was formerly Vice Dean and Director of Wharton Doctoral Programs and Executive Editor of the Review of Financial Studies, one of the leading academic finance journals. He is a past President of the American Finance Association, the Western Finance Association, the Society for Financial Studies, and the Financial Intermediation Research Society. He received his doctorate from Oxford University. Dr. Allen's main areas of interest are corporate finance, asset pricing, financial innovation and comparative financial systems.
Douglas Gale received his PhD in Economics from the University of Cambridge and was elected to a Junior Research Fellowship at Churchill College, Cambridge. He has taught at the London School of Economics and the University of Pennsylvania and is currently Julius Silver Professor of Economics at New York University and an Extraordinary Fellow of Churchill College, Cambridge. He has served as the co-editor of Econometrica and Economic Theory, an associate editor of the Journal of Economic Theory, the Journal of Mathematical Economics, and Research in Economics, and an advisory editor of Macroeconomic Dynamics. He became a Fellow of the Econometric Society in 1987 and is currently a Senior Fellow of the Financial Institutions Center at the Wharton School of the University of Pennsylvania. He is the author of several books and a large number of articles on economic theory and financial economics.

Table of Contents

History and institutions	p. 1
Introduction	p. 1
Historical crises in Europe and the US	p. 2
Crises and stock market crashes	p. 5
Currency and twin crises	p. 9
Crises in different eras	p. 10
Some recent crises	p. 14
The Scandinavian crises	p. 14
Japan	p. 15
The Asian crisis	p. 15
The Russian crisis and long term capital management (LTCM)	p. 16
The Argentina crisis of 2001-2002	p. 17
The costs of crises	p. 18
Theories of crises	p. 19
Concluding remarks	p. 23
Time, uncertainty, and liquidity	p. 27
Efficient allocation over time	p. 27
Consumption and saving	p. 27
Production	p. 36
Uncertainty	p. 40
Contingent commodities and risk sharing	p. 40
Attitudes toward risk	p. 44
Insurance and risk pooling	p. 48
Portfolio choice	p. 49
Liquidity	p. 52
Concluding remarks	p. 57
Intermediation and crises	p. 58
The liquidity problem	p. 59
Market equilibrium	p. 60
The efficient solution	p. 64
The banking solution	p. 72
Bank runs	p. 74
Equilibrium bank runs	p. 76
The business cycle view of bank runs	p. 82
The global games approach to finding a unique equilibrium	p. 90
Literature review	p. 94
Concluding remarks	p. 96
Asset markets	p. 99
Market participation	p. 99
The model	p. 103
Equilibrium	p. 104
Market-clearing at date 1	p. 107
Portfolio choice	p. 109
Cash-in-the-market pricing	p. 110
Limited participation	p. 114
The model	p. 116
Equilibrium	p. 117
Equilibrium with full participation	p. 120
Full participation and asset-price volatility	p. 120
Limited participation and asset-price volatility	p. 121
Multiple Pareto-ranked equilibria	p. 123
Summary	p. 124
Financial fragility	p. 126
Markets, banks, and consumers	p. 128
Types of equilibrium	p. 132
Fundamental equilibrium with no aggregate uncertainty	p. 133
Aggregate uncertainty	p. 135
Sunspot equilibria	p. 140
Idiosyncratic liquidity shocks for banks	p. 142
Equilibrium without bankruptcy	p. 144
Complete versus incomplete markets	p. 146
Relation to the literature	p. 147
Discussion	p. 148
Intermediation and markets	p. 153
Complete markets	p. 155
Intermediation and markets	p. 164
Efficient risk sharing	p. 165
Equilibrium with complete financial markets	p. 167
An alternative formulation of complete markets	p. 170
The general case	p. 172
Implementing the first best without complete markets	p. 177
Incomplete contracts	p. 181
Complete markets and aggregate risk	p. 182
The intermediary's problem with incomplete markets	p. 186
Conclusion	p. 188
Optimal regulation	p. 190
Capital regulation	p. 191
Optimal capital structure	p. 194
Models with aggregate uncertainty	p. 199
Capital structure with complete markets	p. 201
Regulating liquidity	p. 204
Comparative statics	p. 206
Too much or too little liquidity?	p. 209
Literature review	p. 213
Concluding remarks	p. 213
Money and prices	p. 216
An example	p. 218
Optimal currency crises	p. 223
Dollarization and incentives	p. 226
Literature review	p. 228
Concluding remarks	p. 232
Bubbles and crises	p. 235
Agency problems and positive bubbles	p. 237
The risk-shifting problem	p. 238
Credit and interest rate determination	p. 243
Financial risk	p. 245
Financial fragility	p. 246
Banking crises and negative bubbles	p. 247
The model	p. 247
Optimal risk sharing	p. 248
Optimal deposit contracts	p. 251
An asset market	p. 252
Optimal monetary policy	p. 256
Concluding remarks	p. 258
Contagion	p. 260
Liquidity preference	p. 263
Optimal risk sharing	p. 266
Decentralization	p. 268
Contagion	p. 274
The liquidation "pecking order" '	p. 275
Liquidation values	p. 276
Buffers and bank runs	p. 277
Many regions	p. 280
Robustness	p. 280
Containment	p. 281
Discussion	p. 282
Applications	p. 284
Upper and Worms (2004)	p. 284
Degryse and Nguyen (2004)	p. 290
Cifuentes, Ferrucci, and Shin (2005)	p. 291
Literature review	p. 293
Concluding remarks	p. 295
Index	p. 299
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