Working Paper: NBER ID: w3934
Authors: Frederic S. Mishkin
Abstract: This paper provides an asymmetric information framework for understanding the nature of financial crises. It provides the following precise definition of a financial crisis: A financial crisis is a disruption to financial markets in which adverse selection and moral hazard problems become much worse, so that financial markets are unable to efficiently channel funds to those who have the most productive investment opportunities. As a result, a financial crisis can drive the economy away from an equilibrium with high output in which financial markets perform well to one in which output declines sharply. The asymmetric information framework explains the patterns in the data and many features of these crises which are otherwise hard to explain. It indicates that financial crises have effects over and above those resulting from bank panics and therefore provides a rationale for an expanded lender-of-last resort role for the central bank in which the central bank uses the discount window to provide liquidity to sectors outside of the banking system.
Keywords: financial crisis; asymmetric information; adverse selection; moral hazard
JEL Codes: E44; G01
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| financial crises (G01) | disruption of financial markets (F65) |
| disruption of financial markets (F65) | decline in economic activity (F44) |
| adverse selection (D82) | lenders' reluctance to lend (G21) |
| lenders' reluctance to lend (G21) | reduction in overall investment (G31) |
| reduction in overall investment (G31) | decline in economic output (F44) |
| financial crises (G01) | worsened adverse selection (D82) |
| financial crises (G01) | worsened moral hazard (H84) |
| increases in interest rates (E43) | lenders' reluctance to lend (G21) |
| stock market declines (G10) | lenders' reluctance to lend (G21) |
| heightened uncertainty (D89) | lenders' reluctance to lend (G21) |
| worsened adverse selection (D82) | inefficient capital allocation (D61) |
| worsened moral hazard (H84) | inefficient capital allocation (D61) |