Understanding Financial Crises

Understanding Financial Crises

Understanding Financial Crises

Understanding Financial Crises


What causes a financial crisis? Can financial crises be anticipated or even avoided? What can be done to lessen their impact? Should governments and international institutions intervene? Or should financial crises be left to run their course? In the aftermath of the recent Asian financial crisis, many blamed international institutions, corruption, governments, and flawed macro and microeconomic policies not only for causing the crisis but also unnecessarily lengthening and deepening it.

Based on ten years of research, the authors develop a theoretical approach to analyzing financial crises. Beginning with a review of the history of financial crises and providing readers with the basic economic tools needed to understand the literature, the authors construct a series of increasingly sophisticated models. Throughout, the authors guide the reader through the existing theoretical and empirical literature while also building on their own theoretical approach. The text presents the modern theory of intermediation, introduces asset markets and the causes of asset price volatility, and discusses the interaction of banks and markets. The book also deals with more specialized topics, including optimal financial regulation, bubbles, and financial contagion.


This book has grown out of a series of papers written over a number of years. Our paper [Liquidity Preference, Market Participation, and Asset Price Volatility] was actually begun by one of us in 1988, although it appeared in 1994. Our interest in bank runs and financial crises began with [Optimal Financial Crises,] and this led to further studies on the welfare economics of crises. Each paper seemed to leave questions unanswered and led to new papers which led to new questions.

When one of us was invited to give the Clarendon Lectures in Finance, it seemed the right time to begin the task of synthesizing the ideas presented in a variety of different places using different models. Our aim was to make these ideas accessible to a wider audience, including undergraduates and policy makers in central banks and international organizations, and also to put them in a coherent framework that might make them more useful for graduate students and researchers. This is far from being the last word on the subject, but it may provide a set of tools that will be helpful in pursuing the many open questions that remain.

Over the years we have had many opportunities to present our work in seminars and at conferences and have benefited from the comments and suggestions of many economists. In particular, we would like to thank Viral Acharya, Christina Bannier, Michael Bordo, Patrick Bolton, Mike Burkart, Mark Carey, Elena Carletti, Michael Chui, Marco Cipriani, Peter Englund, Prasanna Gai, Gary Gorton, Antonio Guarino, Martin Hellwig, Marcello Pericoli, Glen Hoggarth, Jamie McAndrews, Robert Nobay, Önür Ozgur, Joâo Santos, Massimo Sbracia, Hyun Song Shin, Giancarlo Spagnolo, Xavier Vives, David Webb, Andrew Winton, and Tanju Yorulmazer.

We have included some of these topics in graduate courses we taught at New York University and Princeton University. Once we began writing the book, we were fortunate to have the opportunity to present lecture series at the Bank of England, the Banca d'ltalia, the Stockholm School of Economics, and the University of Frankfurt. We developed an undergraduate course on financial crises at NYU based on the manuscript of the book. We are very grateful to the undergraduates who allowed us to experiment on them and rose to the challenge presented by the material. Antonio Guarino used several chapters for . . .

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