Financial institutions and the financial crisis in East Asia

Abstract

This paper investigates institutional reasons for the soft-budget constraint problem; and how the soft-budget constraint problem creates conditions which may result in a financial crisis. As a consequence of soft-budget constraints, bad projects do not stop; bad loans accumulate; and banks and depositors do not receive bad news on time. Poorly informed depositors are then likely to herd to overinvest when there is no bankruptcy ('frenzy'); and they are likely to herd to panic when bankruptcy occurs ('crash'), which may be the result of excessive bad loans that are also a consequence of soft-budget constraints. In contrast, under hard-budget constraints information is disclosed quickly regarding liquidation. Better-informed investors are then less likely to herd wrongly.