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Causes and Consequences of Systemic Financial Crisis

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Of all the types of risks to banks, the focus here is on liquidity risk, which is the inability to obtain funding to finance operations, though it may be linked to interest-rate and credit risk. Although most of the analysis covers banks, these concepts can also be applied to other financial institutions and even securities markets. Any event, however extraneous, but including runs on or insolvency of other banks can according to Diamond and Dybvig (1983), provoke such runs. Such an effect might be particularly potent for banks, which are creditors of the bank in distress.

Runs are also likely when the equity of banks is a small proportion of balance-sheet totals, as depositors fears of moral hazard increase, assuming managers actions cannot be perfectly monitored (L. And, more generally, in the presence of asymmetric information, which arises from banks creation of non-marketable assets, runs may be triggered by any event that makes depositors change their beliefs about banks riskiness. These might include leading indicators of recession or a decline in net worth of a particular class of borrowers.

Runs may be particularly likely when such bad news follows a phase of speedy growth in credit when the leverage of banks and borrowers is most extended (Calomiris and Gorton, 1991). It may also involve failure of other, particularly large, institutions where there is a suspicion that balance sheets are similarly weak and un-diversified. Again, the non-marketable nature of bank assets means a bank cannot easily prove otherwise. Payments system failure may provoke runs on banks unable to settle their accounts. Finally, outstanding contingent guarantees that banks may issue (e.

back-up lines of credit) may aggravate effects of liquidity problems, since beneficiaries may exercise their claims at the same time as banks are in difficulty. Runs can lead to economic disruption in various ways. To the extent that these are externalities, the bank concerned does not take them into account in its own portfolio decisions, and they thus constitute an a priori basis for public intervention.    

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