Seventh Edition - The Addison-Wesley Series in Economics Phần 4 ppsx

Financial Crises and Aggregate Economic Activity
Agency theory, our economic analysis of the effects of adverse selection and moral
hazard, can help us understand financial crises, major disruptions in financial mar-
kets that are characterized by sharp declines in asset prices and the failures of many
financial and nonfinancial firms. Financial crises have been common in most coun-
tries throughout modern history. The United States experienced major financial crises
in 1819, 1837, 1857, 1873, 1884, 1893, 1907, and 1930–1933 but has not had a
full-scale financial crisis since then.
6
Studying financial crises is worthwhile because
they have led to severe economic downturns in the past and have the potential for
doing so in the future.
Financial crises occur when there is a disruption in the financial system that
causes such a sharp increase in adverse selection and moral hazard problems in finan-
cial markets that the markets are unable to channel funds efficiently from savers to
people with productive investment opportunities. As a result of this inability of finan-
cial markets to function efficiently, economic activity contracts sharply.
To understand why banking and financial crises occur and, more specifically, how
they lead to contractions in economic activity, we need to examine the factors that
cause them. Five categories of factors can trigger financial crises: increases in interest
rates, increases in uncertainty, asset market effects on balance sheets, problems in the
banking sector, and government fiscal imbalances.
Increases in Interest Rates. As we saw earlier, individuals and firms with the riskiest
investment projects are exactly those who are willing to pay the highest interest rates.
If market interest rates are driven up sufficiently because of increased demand for
credit or because of a decline in the money supply, good credit risks are less likely to
want to borrow while bad credit risks are still willing to borrow. Because of the result-
ing increase in adverse selection, lenders will no longer want to make loans. The sub-
stantial decline in lending will lead to a substantial decline in investment and
aggregate economic activity.
Increases in Uncertainty. A dramatic increase in uncertainty in financial markets, due

perhaps to the failure of a prominent financial or nonfinancial institution, a recession,
or a stock market crash, makes it harder for lenders to screen good from bad credit
risks. The resulting inability of lenders to solve the adverse selection problem makes
them less willing to lend, which leads to a decline in lending, investment, and aggre-
gate economic activity.
Asset Market Effects on Balance Sheets. The state of firms’ balance sheets has impor-
tant implications for the severity of asymmetric information problems in the financial
system. A sharp decline in the stock market is one factor that can cause a serious dete-
rioration in firms’ balance sheets that can increase adverse selection and moral hazard
Factors Causing
Financial Crises
CHAPTER 8
An Economic Analysis of Financial Structure
189
6
Although we in the United States have not experienced any financial crises since the Great Depression, we have
had several close calls—the October 1987 stock market crash, for example. An important reason why we have
escaped financial crises is the timely action of the Federal Reserve to prevent them during episodes like that of
October 1987. We look at the issue of the Fed’s role in preventing financial crises in Chapter 17.
problems in financial markets and provoke a financial crisis. A decline in the stock
market means that the net worth of corporations has fallen, because share prices are
the valuation of a corporation’s net worth. The decline in net worth as a result of a
stock market decline makes lenders less willing to lend because, as we have seen, the
net worth of a firm plays a role similar to that of collateral. When the value of collat-
eral declines, it provides less protection to lenders, meaning that losses on loans are
likely to be more severe. Because lenders are now less protected against the conse-
quences of adverse selection, they decrease their lending, which in turn causes invest-
ment and aggregate output to decline. In addition, the decline in corporate net worth
as a result of a stock market decline increases moral hazard by providing incentives for
borrowing firms to make risky investments, as they now have less to lose if their invest-

ments go sour. The resulting increase in moral hazard makes lending less attractive—
another reason why a stock market decline and resultant decline in net worth leads
to decreased lending and economic activity.
In economies in which inflation has been moderate, which characterizes most
industrialized countries, many debt contracts are typically of fairly long maturity with
fixed interest rates. In this institutional environment, unanticipated declines in the
aggregate price level also decrease the net worth of firms. Because debt payments are
contractually fixed in nominal terms, an unanticipated decline in the price level raises
the value of firms’ liabilities in real terms (increases the burden of the debt) but does
not raise the real value of firms’ assets. The result is that net worth in real terms (the
difference between assets and liabilities in real terms) declines. A sharp drop in the
price level therefore causes a substantial decline in real net worth and an increase in
adverse selection and moral hazard problems facing lenders. An unanticipated decline
in the aggregate price level thus leads to a drop in lending and economic activity.
Because of uncertainty about the future value of the domestic currency in devel-
oping countries (and in some industrialized countries), many nonfinancial firms,
banks, and governments in these countries find it easier to issue debt denominated in
foreign currencies. This can lead to a financial crisis in a similar fashion to an unan-
ticipated decline in the price level. With debt contracts denominated in foreign cur-
rency, when there is an unanticipated decline in the value of the domestic currency,
the debt burden of domestic firms increases. Since assets are typically denominated in
domestic currency, there is a resulting deterioration in firms’ balance sheets and a
decline in net worth, which then increases adverse selection and moral hazard prob-
lems along the lines just described. The increase in asymmetric information problems
leads to a decline in investment and economic activity.
Although we have seen that increases in interest rates have a direct effect on
increasing adverse selection problems, increases in interest rates also play a role in
promoting a financial crisis through their effect on both firms’ and households’ bal-
ance sheets. A rise in interest rates and therefore in households’ and firms’ interest
payments decreases firms’ cash flow, the difference between cash receipts and cash

expenditures. The decline in cash flow causes a deterioration in the balance sheet
because it decreases the liquidity of the household or firm and thus makes it harder
for lenders to know whether the firm or household will be able to pay its bills. As a
result, adverse selection and moral hazard problems become more severe for poten-
tial lenders to these firms and households, leading to a decline in lending and eco-
nomic activity. There is thus an additional reason why sharp increases in interest rates
can be an important factor leading to financial crises.
190 PART III
Financial Institutions
Problems in the Banking Sector. Banks play a major role in financial markets because
they are well positioned to engage in information-producing activities that facilitate
productive investment for the economy. The state of banks’ balance sheets has an
important effect on bank lending. If banks suffer a deterioration in their balance
sheets and so have a substantial contraction in their capital, they will have fewer
resources to lend, and bank lending will decline. The contraction in lending then
leads to a decline in investment spending, which slows economic activity.
If the deterioration in bank balance sheets is severe enough, banks will start to
fail, and fear can spread from one bank to another, causing even healthy banks to go
under. The multiple bank failures that result are known as a bank panic. The source
of the contagion is again asymmetric information. In a panic, depositors, fearing for
the safety of their deposits (in the absence of deposit insurance) and not knowing the
quality of banks’ loan portfolios, withdraw their deposits to the point that the banks
fail. The failure of a large number of banks in a short period of time means that there
is a loss of information production in financial markets and hence a direct loss of
financial intermediation by the banking sector. The decrease in bank lending during
a financial crisis also decreases the supply of funds to borrowers, which leads to
higher interest rates. The outcome of a bank panic is an increase in adverse selection
and moral hazard problems in credit markets: These problems produce an even
sharper decline in lending to facilitate productive investments that leads to an even
more severe contraction in economic activity.

Government Fiscal Imbalances. In emerging market countries (Argentina, Brazil, and
Turkey are recent examples), government fiscal imbalances may create fears of default
on the government debt. As a result, the government may have trouble getting peo-
ple to buy its bonds and so it might force banks to purchase them. If the debt then
declines in price—which, as we have seen in Chapter 6, will occur if a government
default is likely—this can substantially weaken bank balance sheets and lead to a con-
traction in lending for the reasons described earlier. Fears of default on the govern-
ment debt can also spark a foreign exchange crisis in which the value of the domestic
currency falls sharply because investors pull their money out of the country. The
decline in the domestic currency’s value will then lead to the destruction of the bal-
ance sheets of firms with large amounts of debt denominated in foreign currency.
These balance sheet problems lead to an increase in adverse selection and moral haz-
ard problems, a decline in lending, and a contraction of economic activity.
CHAPTER 8
An Economic Analysis of Financial Structure
191
Financial Crises in the United States
Application
As mentioned, the United States has a long history of banking and financial
crises, such crises having occurred every 20 years or so in the nineteenth and
early twentieth centuries—in 1819, 1837, 1857, 1873, 1884, 1893, 1907,
and 1930–1933. Our analysis of the factors that lead to a financial crisis can
explain why these crises took place and why they were so damaging to the
U.S. economy.
192 PART III
Financial Institutions
Study Guide To understand fully what took place in a U.S. financial crisis, make sure that
you can state the reasons why each of the factors—increases in interest rates,
increases in uncertainty, asset market effects on balance sheets, and problems
in the banking sector—increases adverse selection and moral hazard prob-

lems, which in turn lead to a decline in economic activity. To help you under-
stand these crises, you might want to refer to Figure 3, a diagram that traces
the sequence of events in a U.S. financial crisis.
As shown in Figure 3, most financial crises in the United States have
begun with a deterioration in banks’ balance sheets, a sharp rise in interest
rates (frequently stemming from increases in interest rates abroad), a steep
stock market decline, and an increase in uncertainty resulting from a failure
of major financial or nonfinancial firms (the Ohio Life Insurance & Trust
Company in 1857, the Northern Pacific Railroad and Jay Cooke & Company
in 1873, Grant & Ward in 1884, the National Cordage Company in 1893,
the Knickerbocker Trust Company in 1907, and the Bank of United States in
1930). During these crises, deterioration in banks’ balance sheets, the
increase in uncertainty, the rise in interest rates, and the stock market decline
increased the severity of adverse selection problems in credit markets; the
stock market decline, the deterioration in banks’ balance sheets, and the rise
in interest rates, which decreased firms’ cash flow, also increased moral haz-
ard problems. The rise in adverse selection and moral hazard problems then
made it less attractive for lenders to lend and led to a decline in investment and
aggregate economic activity.
Because of the worsening business conditions and uncertainty about
their bank’s health (perhaps banks would go broke), depositors began to
withdraw their funds from banks, which led to bank panics. The resulting
decline in the number of banks raised interest rates even further and
decreased the amount of financial intermediation by banks. Worsening of the
problems created by adverse selection and moral hazard led to further eco-
nomic contraction.
Finally, there was a sorting out of firms that were insolvent (had a neg-
ative net worth and hence were bankrupt) from healthy firms by bankruptcy
proceedings. The same process occurred for banks, often with the help of
public and private authorities. Once this sorting out was complete, uncer-

tainty in financial markets declined, the stock market underwent a recovery,
and interest rates fell. The overall result was that adverse selection and moral
hazard problems diminished and the financial crisis subsided. With the
financial markets able to operate well again, the stage was set for the recov-
ery of the economy.
If, however, the economic downturn led to a sharp decline in prices, the
recovery process was short-circuited. In this situation, shown in Figure 3, a
process called debt deflation occurred, in which a substantial decline in the
price level set in, leading to a further deterioration in firms’ net worth
because of the increased burden of indebtedness. When debt deflation set in,
www.amatecon.com/gd
/gdtimeline.html
A time line of the
Great Depression.
CHAPTER 8
An Economic Analysis of Financial Structure
193
the adverse selection and moral hazard problems continued to increase so
that lending, investment spending, and aggregate economic activity remained
depressed for a long time. The most significant financial crisis that included
debt deflation was the Great Depression, the worst economic contraction in
U.S. history (see Box 3).
FIGURE 3 Sequence of Events in U.S. Financial Crises
The solid arrows trace the sequence of events in a typical financial crisis; the dotted arrows show the additional set of events that occur if the
crisis develops into a debt deflation.
Consequences of Changes in Factors
Factors Causing Financial Crises
Typical
Financial
Crisis

Debt
Deflation
Increase in
Interest Rates
Increase in
Uncertainty
Stock Market
Decline
Unanticipated Decline
in Price Level
Bank
Panic
Economic Activity
Declines
Economic Activity
Declines
Economic Activity
Declines
Adverse Selection and Moral
Hazard Problems Worsen
Adverse Selection and Moral
Hazard Problems Worsen
Adverse Selection and Moral
Hazard Problems Worsen
Deterioration in
Banks’ Balance Sheets
194 PART III
Financial Institutions
Box 3
Case Study of a Financial Crisis

The Great Depression. Federal Reserve officials
viewed the stock market boom of 1928 and 1929, dur-
ing which stock prices doubled, as excessive specula-
tion. To curb it, they pursued a tight monetary policy to
raise interest rates. The Fed got more than it bargained
for when the stock market crashed in October 1929.
Although the 1929 crash had a great impact on the
minds of a whole generation, most people forget that
by the middle of 1930, more than half of the stock
market decline had been reversed. What might have
been a normal recession turned into something far
different, however, with adverse shocks to the agri-
cultural sector, a continuing decline in the stock mar-
ket after the middle of 1930, and a sequence of bank
collapses from October 1930 until March 1933 in
which over one-third of the banks in the United
States went out of business (events described in more
detail in Chapter 18).
The continuing decline in stock prices after mid-
1930 (by mid-1932 stocks had declined to 10% of
their value at the 1929 peak) and the increase in
uncertainty from the unsettled business conditions
created by the economic contraction made adverse
selection and moral hazard problems worse in the
credit markets. The loss of one-third of the banks
reduced the amount of financial intermediation. This
intensified adverse selection and moral hazard prob-
lems, thereby decreasing the ability of financial mar-
kets to channel funds to firms with productive
investment opportunities. As our analysis predicts,

the amount of outstanding commercial loans fell by
half from 1929 to 1933, and investment spending
collapsed, declining by 90% from its 1929 level.
The short-circuiting of the process that kept the
economy from recovering quickly, which it does in
most recessions, occurred because of a fall in the
price level by 25% in the 1930–1933 period. This
huge decline in prices triggered a debt deflation in
which net worth fell because of the increased burden
of indebtedness borne by firms. The decline in net
worth and the resulting increase in adverse selection
and moral hazard problems in the credit markets led
to a prolonged economic contraction in which unem-
ployment rose to 25% of the labor force. The finan-
cial crisis in the Great Depression was the worst ever
experienced in the United States, and it explains why
this economic contraction was also the most severe
one ever experienced by the nation.*
*See Ben Bernanke, “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression,” American Economic Review 73 (1983): 257–276, for a
discussion of the role of asymmetric information problems in the Great Depression period.
Financial Crises in Emerging-Market Countries: Mexico,
1994–1995; East Asia, 1997–1998; and Argentina, 2001–2002
Application
In recent years, many emerging-market countries have experienced financial
crises, the most dramatic of which were the Mexican crisis, which started in
December 1994; the East Asian crisis, which started in July 1997; and the
Argentine crisis, which started in 2001. An important puzzle is how a devel-
oping country can shift dramatically from a path of high growth before a
financial crisis—as was true for Mexico and particularly the East Asian coun-
tries of Thailand, Malaysia, Indonesia, the Philippines, and South Korea—to a

sharp decline in economic activity. We can apply our asymmetric information
CHAPTER 8
An Economic Analysis of Financial Structure
195
analysis of financial crises to explain this puzzle and to understand the
Mexican, East Asian, and Argentine financial situations.
7
Because of the different institutional features of emerging-market coun-
tries’ debt markets, the sequence of events in the Mexican, East Asian, and
Argentine crises is different from that occurring in the United States in the
nineteenth and twentieth centuries. Figure 4 diagrams the sequence of events
that occurred in Mexico, East Asia, and Argentina.
An important factor leading up to the financial crises in Mexico and East
Asia was the deterioration in banks’ balance sheets because of increasing loan
losses. When financial markets in these countries were deregulated in the
early 1990s, a lending boom ensued in which bank credit to the private non-
financial business sector accelerated sharply. Because of weak supervision by
bank regulators and a lack of expertise in screening and monitoring borrow-
ers at banking institutions, losses on the loans began to mount, causing an
erosion of banks’ net worth (capital). As a result of this erosion, banks had
fewer resources to lend, and this lack of lending eventually led to a contrac-
tion in economic activity.
Argentina also experienced a deterioration in bank balance sheets lead-
ing up to its crisis, but the source of this deterioration was quite different. In
contrast to Mexico and the East Asian crisis countries, Argentina had a well-
supervised banking system, and a lending boom did not occur before the cri-
sis. On the other hand, in 1998 Argentina entered a recession (you can find
out more on why this occurred in Chapter 20) that led to some loan losses.
However, it was the fiscal problems of the Argentine government that led to
severe weakening of bank balance sheets. Again in contrast to Mexico and the

East Asian countries before their crises, Argentina was running substantial
budget deficits that could not be financed by foreign borrowing. To solve its
fiscal problems, the Argentine government coerced banks into absorbing
large amounts of government debt. When investors lost confidence in the
ability of the Argentine government to repay this debt, the price of this debt
plummeted, leaving big holes in commercial banks’ balance sheets. This
weakening in bank balance sheets, as in Mexico and East Asia, helped lead to
a contraction of economic activity.
Consistent with the U.S. experience in the nineteenth and early twenti-
eth centuries, another precipitating factor in the Mexican and Argentine (but
not East Asian) financial crises was a rise in interest rates abroad. Before the
Mexican crisis, in February 1994, and before the Argentine crisis, in mid-
1999, the Federal Reserve began a cycle of raising the federal funds rate to
head off inflationary pressures. Although the monetary policy moves by the
Fed were quite successful in keeping inflation in check in the United States,
they put upward pressure on interest rates in both Mexico and Argentina.
7
This chapter does not examine two other recent crises, those in Brazil and Russia. Russia’s financial crisis in
August 1998 can also be explained with the asymmetric information story here, but it is more appropriate to view
it as a symptom of a wider breakdown in the economy—and this is why we do not focus on it here. The Brazilian
crisis in January 1999 has features of a more traditional balance-of-payments crisis (see Chapter 20), rather than
a financial crisis.
196 PART III
Financial Institutions
Increase in
Interest Rates
Increase in
Uncertainty
Deterioration in
Banks’ Balance Sheets

Fiscal
Imbalances
Stock Market
Decline
Banking
Crisis
Foreign Exchange
Crisis
Economic Activity
Declines
Economic Activity
Declines
Adverse Selection and Moral
Hazard Problems Worsen
Adverse Selection and Moral
Hazard Problems Worsen
Adverse Selection and Moral
Hazard Problems Worsen
Consequences of Changes in Factors
Factors Causing Financial Crises
FIGURE 4 Sequence of Events in the Mexican, East Asian, and Argentine Financial Crises
The arrows trace the sequence of events during the financial crisis.
The rise in interest rates in Mexico and Argentina directly added to increased
adverse selection in their financial markets because, as discussed earlier, it
was more likely that the parties willing to take on the most risk would seek
loans.
Also consistent with the U.S. experience in the nineteenth and early
twentieth centuries, stock market declines and increases in uncertainty
occurred prior to and contributed to full-blown crises in Mexico, Thailand,
CHAPTER 8

An Economic Analysis of Financial Structure
197
South Korea, and Argentina. (The stock market declines in Malaysia,
Indonesia, and the Philippines, on the other hand, occurred simultaneously
with the onset of the crisis.) The Mexican economy was hit by political
shocks in 1994 (specifically, the assassination of the ruling party’s presiden-
tial candidate and an uprising in the southern state of Chiapas) that created
uncertainty, while the ongoing recession increased uncertainty in Argentina.
Right before their crises, Thailand and Korea experienced major failures of
financial and nonfinancial firms that increased general uncertainty in finan-
cial markets
As we have seen, an increase in uncertainty and a decrease in net worth
as a result of a stock market decline increase asymmetric information prob-
lems. It becomes harder to screen out good from bad borrowers, and the
decline in net worth decreases the value of firms’ collateral and increases their
incentives to make risky investments because there is less equity to lose if the
investments are unsuccessful. The increase in uncertainty and stock market
declines that occurred before the crisis, along with the deterioration in banks’
balance sheets, worsened adverse selection and moral hazard problems
(shown at the top of the diagram in Figure 4) and made the economies ripe
for a serious financial crisis.
At this point, full-blown speculative attacks developed in the foreign
exchange market, plunging these countries into a full-scale crisis. With the
Colosio assassination, the Chiapas uprising, and the growing weakness in the
banking sector, the Mexican peso came under attack. Even though the Mexican
central bank intervened in the foreign exchange market and raised interest
rates sharply, it was unable to stem the attack and was forced to devalue the
peso on December 20, 1994. In the case of Thailand, concerns about the
large current account deficit and weakness in the Thai financial system, cul-
minating with the failure of a major finance company, Finance One, led to a

successful speculative attack that forced the Thai central bank to allow the
baht to float downward in July 1997. Soon thereafter, speculative attacks
developed against the other countries in the region, leading to the collapse of
the Philippine peso, the Indonesian rupiah, the Malaysian ringgit, and the
South Korean won. In Argentina, a full-scale banking panic began in
October–November 2001. This, along with realization that the government
was going to default on its debt, also led to a speculative attack on the
Argentine peso, resulting in its collapse on January 6, 2002.
The institutional structure of debt markets in Mexico and East Asia now
interacted with the currency devaluations to propel the economies into full-
fledged financial crises. Because so many firms in these countries had debt
denominated in foreign currencies like the dollar and the yen, depreciation
of their currencies resulted in increases in their indebtedness in domestic
currency terms, even though the value of their assets remained unchanged.
When the peso lost half its value by March 1995 and the Thai, Philippine,
Malaysian, and South Korean currencies lost between a third and half of their
value by the beginning of 1998, firms’ balance sheets took a big negative hit,
causing a dramatic increase in adverse selection and moral hazard problems.
This negative shock was especially severe for Indonesia and Argentina, which
saw the value of their currencies fall by over 70%, resulting in insolvency for
firms with substantial amounts of debt denominated in foreign currencies.
198 PART III
Financial Institutions
The collapse of currencies also led to a rise in actual and expected
inflation in these countries, and market interest rates rose sky-high (to
around 100% in Mexico and Argentina). The resulting increase in interest
payments caused reductions in households’ and firms’ cash flow, which led
to further deterioration in their balance sheets. A feature of debt markets in
emerging-market countries, like those in Mexico, East Asia, and Argentina
is that debt contracts have very short durations, typically less than one

month. Thus the rise in short-term interest rates in these countries meant
that the effect on cash flow and hence on balance sheets was substantial. As
our asymmetric information analysis suggests, this deterioration in house-
holds’ and firms’ balance sheets increased adverse selection and moral haz-
ard problems in the credit markets, making domestic and foreign lenders
even less willing to lend.
Consistent with the theory of financial crises outlined in this chapter, the
sharp decline in lending helped lead to a collapse of economic activity, with
real GDP growth falling sharply.
As shown in Figure 4, further deterioration in the economy occurred
because the collapse in economic activity and the deterioration in the cash
flow and balance sheets of both firms and households led to worsening bank-
ing crises. The problems of firms and households meant that many of them
were no longer able to pay off their debts, resulting in substantial losses for
the banks. Even more problematic for the banks was that they had many
short-term liabilities denominated in foreign currencies, and the sharp
increase in the value of these liabilities after the devaluation lead to a further
deterioration in the banks’ balance sheets. Under these circumstances, the
banking system would have collapsed in the absence of a government safety
net—as it did in the United States during the Great Depression—but with the
assistance of the International Monetary Fund, these countries were in some
cases able to protect depositors and avoid a bank panic. However, given the
loss of bank capital and the need for the government to intervene to prop up
the banks, the banks’ ability to lend was nevertheless sharply curtailed. As we
have seen, a banking crisis of this type hinders the ability of the banks to lend
and also makes adverse selection and moral hazard problems worse in finan-
cial markets, because banks are less capable of playing their traditional finan-
cial intermediation role. The banking crisis, along with other factors that
increased adverse selection and moral hazard problems in the credit markets
of Mexico, East Asia, and Argentina, explains the collapse of lending and

hence economic activity in the aftermath of the crisis.
In the aftermath of their crises, Mexico began to recover in 1996, while
the crisis countries in East Asia saw the glimmer of recovery in 1999.
Argentina was still in a severe depression in 2003. In all these countries, the
economic hardship caused by the financial crises was tremendous.
Unemployment rose sharply, poverty increased substantially, and even the
social fabric of the society was stretched thin. For example, Mexico City and
Buenos Aires have become crime-ridden, while Indonesia has experienced
waves of ethnic violence.
CHAPTER 8
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199
Summary
1. There are eight basic puzzles about our financial
structure. The first four emphasize the importance of
financial intermediaries and the relative unimportance
of securities markets for the financing of corporations;
the fifth recognizes that financial markets are among the
most heavily regulated sectors of the economy; the sixth
states that only large, well-established corporations
have access to securities markets; the seventh indicates
that collateral is an important feature of debt contracts;
and the eighth presents debt contracts as complicated
legal documents that place substantial restrictions on
the behavior of the borrower.
2. Transaction costs freeze many small savers and
borrowers out of direct involvement with financial
markets. Financial intermediaries can take advantage of
economies of scale and are better able to develop
expertise to lower transaction costs, thus enabling their

savers and borrowers to benefit from the existence of
financial markets.
3. Asymmetric information results in two problems:
adverse selection, which occurs before the transaction,
and moral hazard, which occurs after the transaction.
Adverse selection refers to the fact that bad credit risks
are the ones most likely to seek loans, and moral hazard
refers to the risk of the borrower’s engaging in activities
that are undesirable from the lender’s point of view.
4. Adverse selection interferes with the efficient
functioning of financial markets. Tools to help reduce
the adverse selection problem include private
production and sale of information, government
regulation to increase information, financial
intermediation, and collateral and net worth. The free-
rider problem occurs when people who do not pay for
information take advantage of information that other
people have paid for. This problem explains why
financial intermediaries, particularly banks, play a more
important role in financing the activities of businesses
than securities markets do.
5. Moral hazard in equity contracts is known as the
principal–agent problem, because managers (the
agents) have less incentive to maximize profits than
stockholders (the principals). The principal–agent
problem explains why debt contracts are so much more
prevalent in financial markets than equity contracts.
Tools to help reduce the principal–agent problem
include monitoring, government regulation to increase
information, and financial intermediation.

6. Tools to reduce the moral hazard problem in debt
contracts include net worth, monitoring and enforcement
of restrictive covenants, and financial intermediaries.
7. Financial crises are major disruptions in financial
markets. They are caused by increases in adverse
selection and moral hazard problems that prevent
financial markets from channeling funds to people with
productive investment opportunities, leading to a sharp
contraction in economic activity. The five types of factors
that lead to financial crises are increases in interest rates,
increases in uncertainty, asset market effects on balance
sheets, problems in the banking sector, and government
fiscal imbalances.
Key Terms
agency theory, p. 175, 189
bank panic, p. 191
cash flow, p. 190
collateral, p. 172
costly state verification, p. 182
creditor, p. 188
debt deflation, p. 192
financial crisis, p. 189
free-rider problem, p. 176
incentive-compatible, p. 185
insolvent, p. 192
net worth (equity capital), p. 180
pecking order hypothesis, p. 180
principal–agent problem, p. 181
restrictive covenants, p. 172
secured debt, p. 172

unsecured debt, p. 172
venture capital firm, p. 182
200 PART III
Financial Institutions
Questions and Problems
Questions marked with an asterisk are answered at the end
of the book in an appendix, “Answers to Selected Questions
and Problems.”
1. How can economies of scale help explain the existence
of financial intermediaries?
*2. Describe two ways in which financial intermediaries
help lower transaction costs in the economy.
3. Would moral hazard and adverse selection still arise in
financial markets if information were not asymmetric?
Explain.
*4. How do standard accounting principles required by
the government help financial markets work more effi-
ciently?
5. Do you think the lemons problem would be more
severe for stocks traded on the New York Stock
Exchange or those traded over-the-counter? Explain.
*6. Which firms are most likely to use bank financing
rather than to issue bonds or stocks to finance their
activities? Why?
7. How can the existence of asymmetric information pro-
vide a rationale for government regulation of financial
markets?
*8. Would you be more willing to lend to a friend if she
put all of her life savings into her business than you
would if she had not done so? Why?

9. Rich people often worry that others will seek to marry
them only for their money. Is this a problem of
adverse selection?
*10. The more collateral there is backing a loan, the less
the lender has to worry about adverse selection. Is this
statement true, false, or uncertain? Explain your
answer.
11. How does the free-rider problem aggravate adverse
selection and moral hazard problems in financial
markets?
*12. Explain how the separation of ownership and control in
American corporations might lead to poor management.
13. Is a financial crisis more likely to occur when the
economy is experiencing deflation or inflation?
Explain.
*14. How can a stock market crash provoke a financial crisis?
15. How can a sharp rise in interest rates provoke a finan-
cial crisis?
Web Exercises
1. In this chapter we discuss the lemons problem and its
effect on the efficient functioning of a market. This
theory was initially developed by George Akerlof. Go to
www
.nobel.se/economics/laureates/2001/public.html.
This site reports that Akerlof, Spence, and Stiglitz
were awarded the Nobel prize in economics in 2001
for their work. Read this report down through the sec-
tion on George Akerlof. Summarize his research ideas
in one page.
2. This chapter discusses how an understanding of

adverse selection and moral hazard can help us better
understand financial crises. The greatest financial crisis
faced by the U.S. has been the Great Depression from
1929–1933. Go to www
.amatecon.com/greatdepression
.html. This site contains a brief discussion of the fac-
tors that led to the Depression. Write a one-page sum-
mary explaining how adverse selection and moral
hazard contributed to the Depression.
QUIZ

202 PART III
Financial Institutions
Table 1 Balance Sheet of All Commercial Banks (items as a percentage of the total, January 2003)
Nontransaction Deposits.
Borrowings.
CHAPTER 9
Banking and the Management of Financial Institutions
203
A bank’s borrowings
from the Federal
Reserve System; also
known as advances.
Bank Capital.
Reserves.
Cash Items in Process of Collection.
Deposits at Other Banks.
Securities.
Assets
204 PART III

Financial Institutions
Banks’ holding of
deposits in accounts
with the Fed plus
currency that is
physically held by
banks (vault cash).
Reserves that are held
to meet the Fed’s
requirement that for
every dollar of deposits
at a bank, a certain
fraction must be kept
as reserves.
Regulation making it
obligatory for
depository institutions
to keep a certain
fraction of their
deposits in accounts
with the Fed.
Loans.
Other Assets.
CHAPTER 9
Banking and the Management of Financial Institutions
205
206 PART III
Financial Institutions
when a bank
receives additional deposits, it gains an equal amount of reserves; when it loses

deposits, it loses an equal amount of reserves.
Study Guide
CHAPTER 9
Banking and the Management of Financial Institutions
207
Liquidity
Management
and the Role of
Reserves
208 PART III
Financial Institutions
if a bank has ample reserves, a deposit
outflow does not necessitate changes in other parts of its balance sheet.
CHAPTER 9
Banking and the Management of Financial Institutions
209
210 PART III
Financial Institutions
Excess reserves are insurance against the costs associated with
deposit outflows. The higher the costs associated with deposit outflows, the more
excess reserves banks will want to hold.
Study Guide
Asset
Management
CHAPTER 9
Banking and the Management of Financial Institutions
211
Liability
Management
212 PART III

Financial Institutions
How Bank Capital Helps Prevent Bank Failure.
Capital Adequacy
Management
CHAPTER 9
Banking and the Management of Financial Institutions
213