Theories of financial crises

Itay Goldstein, Assaf Razin, 11 March 2013



Financial and monetary systems are designed to improve the efficiency of real activity and resource allocation. A large empirical literature in financial economics provides evidence connecting financial development to economic growth and efficiency (Levine 1997, Rajan and Zingales 1998). Unfortunately, financial crises, generating extreme disruption of the normal functions of financial and monetary systems, have happened frequently throughout history.

The last five years have been characterised by great turmoil in the world’s financial systems, which took much of the economic profession by surprise. We have witnessed the meltdown of leading financial institutions in the US and Europe, a sharp decrease in lending and trading activities, and the ongoing challenge to the European Monetary Union. Explaining the forces behind the crisis and coming up with suggestions for policymakers on how to solve it and fix the system going forward have become top priorities for many economists1.

These recent events feature familiar ingredients from the history of financial crises. Understanding the theories behind these crises and where these theories need to be further developed is crucial for properly addressing the current challenges and designing the financial systems for the future.

In Goldstein and Razin (2012), we provide an extensive review of three literatures that have been developed over more than three decades, highlighting the analytical underpinnings of three types of crises: banking crises and panics, credit frictions and market freezes, and currency crises2. We argue that features from these types of crises have been at work and interacted with each other to shape the events of the last few years. We address some of the policy challenges that face the global economy today using the analytical tools at hand.

Banking crises and panics

The literature on banking crises and panics goes back to the seminal paper by Diamond and Dybvig (1983). Banks are known to finance long-term assets with short-term deposits. The advantage of this arrangement is that it enables banks to provide risk sharing to investors who might face early liquidity needs. However, this also exposes the bank to the risk of a bank run, whereby many creditors decide to withdraw their money early. The key problem is that of a coordination failure, which stands at the root of the fragility of banking systems: When more depositors withdraw their money from a bank, the bank is more likely to fail, and so other depositors have a stronger incentive to withdraw.

Banking systems have been plagued with bank runs throughout history (see e.g. Calomiris and Gorton 1991). Policy lessons adopted in the early 20th century led governments to insure banks, which substantially reduced the likelihood of such events. However, runs are still a prominent phenomenon behind financial crises, in cases where insurance is partial or does not exist. For example, many bank runs happened in east Asian and Latin American countries in the last two decades. In the recent turmoil, a classic ‘textbook’ type of bank run was seen in the UK for Northern Rock Bank (see Shin 2009), where investors were lining up in the street to withdraw money from their accounts. Beyond that, there were many other less typical examples of runs in the financial system as a whole. The repo market, where investment banks get short-term financing, was subject to a run (Gorton and Metrick 2012) when financing has all of a sudden dried up. This led to the failure of leading financial institutions, such as Bear Stearns and Lehman Brothers. Runs also occurred on money-market funds and in the asset-backed-commercial-paper market (Schroth, Suarez, and Taylor 2012). Chen, Goldstein, and Jiang (2010) show more generally that fragility due to coordination failures is common even in normal times in open-end mutual funds.

A key policy question is how to avoid the damages from coordination failures and runs in the financial system. While insurance has been effective, its implications for moral hazard have to be considered carefully, and so there is room for more research on the optimal deposit insurance policy. Using recent developments in economic theory, global-games models (see, e.g., Carlsson and van Damme 1993), Morris and Shin 1998, Goldstein and Pauzner 2005) enable analysis of the benefit of insurance in mitigating runs against the cost in generating moral hazard, leading to the characterisation of optimal insurance policy.

Credit frictions and market freezes

In the above models of financial-institution failures, the focus was on the behaviour of depositors or creditors of the banks. However, problems in the financial sector often arise from the other side of the balance sheet. The quality of loans provided by the banks is determined in equilibrium, and frictions exist that make banks cut on lending to protect themselves from bad outcomes.

Stiglitz and Weiss (1981) provide a basic rationale for the presence of such credit rationing. While basic economic theory suggests that in equilibrium prices adjust so that supply equals demand and no rationing arises, they show that this will not occur in the credit market due to the endogeneity of the quality of the loan. There are two key frictions that stand behind rationing: moral hazard and adverse selection. A large recent literature studies the implications of such frictions for lending, especially of moral hazard, following the canonical representation offered by Holmstrom and Tirole (1997). In this model, if a borrower has the ability to divert resources at the expense of the creditor, then creditors will be reluctant to lend to borrowers. Hence, for credit to flow efficiently from the creditor to the borrower, it is crucial that the borrower maintains ‘skin in the game’, i.e., that he has enough at stake in the success of the project, and so does not have a strong incentive to divert resources. This creates a limit on credit, and it can be amplified when economic conditions worsen, leading to a crisis.

Such forces were clearly working in recent years. The credit freeze following the financial meltdown of 2008, and the credit flow freeze in the interbank markets are both manifestations of the amplification of economic shocks due to the frictions in credit provision.

A massive amount of effort is invested these days in trying to integrate the literature on credit frictions into macroeconomic models in order to understand the effect that credit frictions have on macroeconomic fluctuations. Going back to Bernanke and Gertler (1989) and Kiyotaki and Moore (1997), it has been shown that credit frictions cause amplification and persistence of small economic shocks. Recently, Gertler and Kiyotaki (2011) and Rampini and Viswanathan (2011) add a financial-intermediary sector and analyse the dynamic interactions between this sector and the rest of the economy. Introducing this sector into macroeconomic models enables elaborate discussions on various policies conducted by governments during the recent crisis.

Currency crises

An important aspect of financial crises is the involvement of the government and the potential collapse of arrangements it creates, such as an exchange-rate regime. Many currency crises, e.g., the early 1970s breakdown of the Bretton Woods global system, originate from the desire of governments to maintain a fixed exchange-rate regime which is inconsistent with other policy goals. This might lead to the sudden collapse of the regime. The literature on currency crises that we review in Goldstein and Razin (2012) starts from the first-generation models of Krugman (1979) and Flood and Garber (1984) and the second-generation models of Obstfeld (1994, 1996).

Such models are highly relevant to the current situation in the European Monetary Union. In the basis of the theory of currency crises is the famous international-finance trilemma, according to which a country can choose only two of three policy goals: free international capital flows, monetary autonomy, and the stability of the exchange rate. Countries in the Eurozone now realise that in their attempt to achieve the first and third goal, they have given up on the second goal, and so have limited ability to absorb the shocks in economic activity and maintain their national debts, triggered by the global financial crisis. Coordination problems among investors and currency speculators aggravate this situation, and may have an important effect on whether individual countries in Europe are forced to default and/or leave the monetary union.

While the traditional literature on currency crises focused on the government alone, the so-called third-generation models of currency crises, which we also review (e.g., Krugman 1999, Chang and Velasco 2001, and Goldstein 2005), connect models of banking crises and credit frictions with traditional models of currency crises. Such models were motivated by the east Asian crises of the late 1990s, where financial institutions and exchange-rate regimes collapsed together, demonstrating the linkages between governments and financial institutions that can expose the system to further fragility. This is again relevant for the current situation in Europe, as banks and governments are intertwined, and the fragility of the system depends to a large extent on the connections between them.

Concluding remarks

A major challenge in policy analysis going forward is to incorporate the frictions highlighted above – coordination failures, incentive problems, asymmetric information, and government constraints – into a macroeconomic model that can be calibrated and provide quantitative output as to the optimal mix and magnitudes of policies. Ideally, central banks will start using models of this sort to replace the existing macroeconomic models. Some work is being done in this direction in the context of credit frictions, but not so much in the other directions. Developing such models is an important challenge for future research.

In addition, while there are many models discussing different forces behind fragility and crises, integrative models that combine the various forces together are lacking (although some exceptions have been mentioned). This remains a major challenge to researchers going forward, since only with an integrative model can one understand the relative contribution of different forces and the interaction between them.


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Brunnermeier, Markus (2009), “Deciphering the liquidity and credit crunch 2007-2008”, Journal of Economic Perspectives 23, 77-100.

Calomiris, Charles, and Gary Gorton (1991), “The origins of banking panics: models, facts, and bank regulation”, in Glenn Hubbard (ed.) Financial Markets and Financial Crises, University of Chicago Press.

Carlsson, Hans, and Eric van Damme (1993), “Global games and equilibrium selection”, Econometrica 61, 989-1018.

Chang, Roberto, and Andres Velasco (2001), “A model of financial crises in emerging markets”, Quarterly Journal of Economics 116, 489-517.

Chen, Qi, Itay Goldstein, and Wei Jiang (2010), “Payoff complementarities and financial fragility: evidence from mutual fund outflows”, Journal of Financial Economics 97, 239-262.

Diamond, Douglas W, and Philip H Dybvig (1983), “Bank runs, deposit insurance, and liquidity”, Journal of Political Economy 91, 401-419.

Flood, Robert, and Peter Garber (1984), “Collapsing exchange-rate regimes, some linear examples”, Journal of International Economics 17, 1-13.

Gertler, Mark, and Nobuhiro Kiyotaki (2011), “Financial Intermediation and Credit Policy”, Handbook of Monetary Economics, forthcoming.

Goldstein, Itay (2005), “Strategic complementarities and the twin crises”, Economic Journal 115, 368-390.

Goldstein, Itay, and Ady Pauzner (2005), “Demand deposit contracts and the probability of bank runs”, Journal of Finance 60, 1293-1328.

Goldstein, Itay, and Assaf Razin (2012), “Review of theories of financial crises”, NBER Working Paper 18670.

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Gorton, Gary, and Andrew Metrick (2012), “Securitized banking and the run on repo”, Journal of Financial Economics 104, 425-451.

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Morris, Stephen, and Hyun S Shin (1998), “Unique equilibrium in a model of self-fulfilling currency attacks”, The American Economic Review 88, 587-597.

Obstfeld, Maurice (1994), “The logic of currency crises”, Cahiers Economiques et Monetaires 43, 189-213.

Obstfeld, Maurice (1996), “Models of Currency Crises with Self-Fulfilling Features”, European Economic Review 40, 1037-1047.

Rajan, Raghuram, and Luigi Zingales (1998), “Financial dependence and growth”, The American Economic Review 88, 559-586.

Rampini, Adriano, and S Viswanathan (2011), “Financial intermediary capital”, Working Paper.

Schroth, Enrique, G Suarez, and L Taylor (2012), “Dynamic debt runs and financial fragility: evidence from the 2007 ABCP crisis”, working paper.

Shin, Hyun S (2009), “Reflections on Northern Rock: the bank run that heralded the global financial crisis”, Journal of Economic Perspectives 23, 101-119.

Stiglitz, Joseph E, and Andrew Weiss (1981), “Credit rationing in markets with imperfect information”, The American Economic Review 71, 393-410.

1 Many authors provide detailed descriptions of the events of the last few years. For example, see Brunnermeier (2009) and Gorton (2010).

2 In Goldstein and Razin (2012), we provide references to many papers in the literature, only a small subset of them are mentioned here.

Topics: Global crisis, Global economy, International finance
Tags: bank runs, Banking crisis, credit frictions, Currency crises, market freezes

Professor of Finance at the Wharton School, University of Pennsylvania

Assaf Razin

Barbara and Steven Friedman Professor of International Economics, Cornell University; Bernard Schwartz Professor (Emeritus), Tel Aviv University

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