US Federal Reserve S97mishk

The Causes and Propagation
of Financial Instability:
Lessons for Policymakers
Frederic S. Mishkin
In the last twenty years, countries throughout the world have

experienced severe bouts of financial instability. Banking crises
have become so common that it is the rare country that has not
experienced one, while full-scale financial crises have struck some
economies with devastating effects. Financial instability, although
a particularly severe problem for emerging-market countries which
suffer disproportionately when it occurs, has struck industrialized
countries just as frequently.
Given our recent record of increased financial instability, it is no

surprise that policymakers throughout the world, and especially
central bankers, have become more concerned about what leads to
financial instability and what can be done to prevent it. This paper
examines what causes and propagates financial instability and
then suggests some lessons for policymakers. A key theme of the
analysis is that the root cause of financial instability is the break-
down of information flows which hinder the efficient functioning
of financial markets. This information approach to understanding
financial instability will enable us to see not only that policymakers
have a key role in assuring that information flows well in financial
markets, but also that they, and particularly central bankers, play a
critical role in promoting financial stability.
55
56 Frederic S. Mishkin
Information and the financial system
Financial markets and institutions perform the essential function

in an economy of channeling funds to those individuals or firms that
have productive investment opportunities. If the financial system
does not perform this role well, then the economy cannot operate
efficiently and economic growth will be severely hampered. Indeed,
the economics literature on financial repression demonstrates that
an important reason why many poor countries remain poor is that
their financial sectors remain underdeveloped.1
A crucial impediment to the efficient functioning of the financial

system is asymmetric information, a situation in which one party to
a financial contract has much less accurate information than the
other party. For example, borrowers who take out loans usually have
much better information about the potential returns and risk associ-
ated with the investment projects they plan to undertake than lenders
do. Asymmetric information leads to two basic problems in the
financial system: adverse selection and moral hazard.
Adverse selection is an asymmetric information problem that

occurs before the transaction occurs when potential bad credit risks
are the ones who most actively seek out a loan. Thus, the parties who
are the most likely to produce an undesirable (adverse) outcome are
most likely to be selected. For example, those who want to take on
big risks are likely to be the most eager to take out a loan because
they know that they are unlikely to pay it back. Since adverse
selection makes it more likely that loans might be made to bad credit
risks, lenders may decide not to make any loans even though there
are good credit risks in the marketplace. This outcome is a feature
of the classic “lemons problem” analysis first described by Akerlof
(1970). Clearly, minimizing the adverse selection problem requires
that lenders must screen out good from bad credit risks.
Moral hazard occurs after the transaction takes place because the
lender is subjected to the hazard that the borrower has incentives to
engage in activities that are undesirable (immoral) from the lender’s
point of view—that is, activities that make it less likely that the loan
The Causes and Propagation of Financial Instability:
Lessons for Policymakers 57
will be paid back. Moral hazard occurs because a borrower has

incentives to invest in projects with high risk in which the borrower
does well if the project succeeds but the lender bears most of the
loss if the project fails. Also the borrower has incentives to misallo-
cate funds for her own personal use, to shirk and just not work very
hard, or to undertake investment in unprofitable projects that
increase her power or stature. The conflict of interest between the
borrower and lender stemming from moral hazard (the agency
problem) implies that many lenders will decide that they would
rather not make loans, so that lending and investment will be at
suboptimal levels.2 In order to minimize the moral hazard problem,
lenders must impose restrictions (restrictive covenants) on borrow-
ers so that borrowers do not engage in behavior that makes it less
likely that they can pay back the loan; then lenders must monitor the
borrowers’ activities and enforce the restrictive covenants if the
borrower violates them.
Another concept that is very important in understanding the impedi-

ments to a well-functioning financial system is the so-called free-
rider problem. The free-rider problem occurs because people who
do not spend resources on collecting information can still take
advantage of (a “free ride” from) the information that other people
have collected. The free-rider problem is particularly important in
securities markets. If some investors acquire information that tells
them which securities are undervalued and then buy these securities,
other investors who have not paid for this information may be able
to buy right along with the well-informed investors. If enough
free-riding investors can do this, the increased demand for the
undervalued securities will cause their low price to be bid up to
reflect the securities’ full net present value given this information.
As a result of all these free riders, investors who have acquired
information will no longer be able to earn the entire increase in the
value of the security arising from this additional information. The
weakened ability of private firms to profit from producing
information will mean that less information is produced in securi-
ties markets, so that the adverse selection problem, in which over-
valued securities are those most often offered for sale, is more likely
to be an impediment to a well-functioning securities market.
More importantly, the free-rider problem makes it less likely that

securities markets will act to reduce incentives to commit moral
hazard. Monitoring and enforcement of restrictive covenants are
necessary to reduce moral hazard. By monitoring borrowers’ activi-
ties to see whether they are complying with the restrictive covenants
and enforcing the covenants if they are not, lenders can prevent
borrowers from taking on risk at their expense. However, because
monitoring and enforcement of restrictive covenants are costly, the
free-rider problem discourages this kind of activity in securities
markets. If some investors know that other securities holders are
monitoring and enforcing the restrictive covenants, then they can
free ride on the other securities holders’ monitoring and enforce-
ment. Once these other securities holders realize that they can do the
same thing, they also may stop their monitoring and enforcement
activities, with the result that not enough resources are devoted to
monitoring and enforcement. The outcome is that moral hazard is
likely to be a severe problem for marketable securities.
The problems created by adverse selection and moral hazard, and

the related free-rider problem, are important impediments to well-
functioning financial markets. Indeed, many institutional features of
financial systems have developed to minimize these asymmetric
information problems.
One important feature of financial systems is the prominent role

played by banking institutions and other financial intermediaries
that make private loans. These financial intermediaries play such an
important role because they are so well-suited to reducing adverse
selection and moral hazard problems in financial markets. They are
not as subject to the free-rider problem and profit from the informa-
tion they produce because they make private loans that are not
traded. Because the loans of financial intermediaries are private,
other investors cannot buy them. As a result, investors are less able
to free ride off financial intermediaries and bid up the prices of the
loans which would prevent the intermediary from profiting from its
information production activities. Similarly, it is hard to free ride off
these financial intermediaries monitoring activities when they make
private loans. Financial institutions making private loans thus receive
the benefits of monitoring and so are better equipped to prevent

moral hazard on the part of borrowers.3
Banks have particular advantages over other financial intermedi-

aries in solving asymmetric information problems. For example,
banks’ advantages in information collection activities are enhanced
by their ability to engage in long-term customer relationships and
issue loans using lines of credit arrangements. In addition their
ability to scrutinize the checking account balances of their borrow-
ers provides banks with an additional advantage in monitoring the
borrowers’ behavior. Banks also have advantages in reducing moral
hazard because, as demonstrated by Diamond (1984), they can
engage in lower-cost monitoring than individuals, and because, as
pointed out by Stiglitz and Weiss (1983), they have advantages in
preventing risk taking by borrowers since they can use the threat of
cutting off lending in the future to improve a borrower’s behavior.
Banks’ natural advantages in collecting information and reducing
moral hazard explain why banks have such an important role in
financial markets throughout the world. Furthermore, the greater
difficulty of acquiring information on private firms in emerging-
market countries makes banks even more important in the financial
systems of these countries.4,5
Asymmetric information problems also explain why, as Mayer

(1990) points out, securities markets are frequently a relatively
unimportant source of external finance to nonfinancial businesses
in industrialized countries. Clearly, the better the quality of infor-
mation about firms, the more likely it is that they can issue securities
to raise funds. This reality suggests why only the largest and best-
known firms in industrialized countries issue securities. In emerging-
market economies, information about private firms is even harder
to collect than in industrialized economies and, not surprisingly,
securities markets therefore play a much smaller role.
The existence of asymmetric information problems also explains

why there is an important role for the government to both regulate
and supervise the financial system. We have seen that minimizing
adverse selection and moral hazard problems requires production of
information through screening and monitoring, and yet not enough

information will be produced because of the free-rider problem. The
government can help come to the rescue by imposing regulations on
the financial system which encourage information production. In the
securities markets, regulation usually takes the form of requiring firms
issuing securities to adhere to standard accounting principles and to
publicly release information about their sales, assets, and earnings.
Governments also pass laws to impose stiff penalties on individuals
who engage in the fraud of either hiding information or stealing profits.
Governments also impose regulations to ensure that financial

institutions adhere to certain standard accounting principles and
disclose a wide range of information that helps the market assess the
quality of the financial institution’s portfolio and the amount of the
institution’s exposure to risk. More public information about the
risks incurred by financial institutions and the quality of their
portfolios can better enable stockholders, creditors, policyholders,
and depositors to monitor these institutions, and so act as a deterrent
to excessive risk taking.
Although disclosure requirements of this type help increase the

amount of information in the marketplace, the free-rider problem
results in insufficient screening and monitoring of financial institutions
by the individuals who provide them with funds. Thus, governments
play a role in imposing restrictions on the asset holdings of these
institutions to prevent them from taking on too much risk. Further-
more, governments impose capital requirements, particularly for
banking institutions, to reduce the incentives of these institutions to
take on risk. When a financial institution is forced to have a large
amount of equity capital, it has more to lose if it fails and is thus less
likely to engage in risky activities. In addition, equity capital in itself
reduces the probability of failure because it provides a cushion to
withstand adverse effects on the institution’s balance sheet.
Another role that governments play in the financial system is to

provide a safety net. This is especially important for banking insti-
tutions that have demandable deposits and private loans. Without a
safety net, a bad shock to the economy can cause depositors to
withdraw funds not only from insolvent banks but also from healthy
institutions because they cannot sort the good from the bad banks.
Indeed, because banks operate on a first-come, first-served basis (the
so-called sequential service constraint), depositors have a very strong
incentive to show up at the bank first because if they are last on line,
the bank may run out of funds and they will get nothing. Therefore,
uncertainty about the health of the banking system in general in the
face of an economy-wide shock can lead to “runs” on banks, both good
and bad, and the failure of one bank can hasten the failure of others,
leading to a contagion effect. If nothing is done to restore the public’s
confidence, a bank panic can ensue in which both solvent and
insolvent banks go out of business, leaving depositors with large losses.
A government safety net for depositors can short circuit runs on

banks and bank panics. Deposit insurance is one form of the safety
net in which depositors, sometimes with a limit to amount and
sometimes not, are insured against losses due to a bank failure. With
fully insured deposits, depositors don’t need to run to the bank to
make withdrawals—even if they are worried about the bank’s
health—because their deposits will be worth 100 cents on the dollar
no matter what. Even with less than full insurance, the incentive for
depositors to run to withdraw deposits when they are unsure about
the bank’s health is decreased.
Deposit insurance is not the only way in which governments

provide a safety net to depositors. Governments often stand ready
to provide support to domestic banks when banks face runs even in
the absence of explicit deposit insurance. This support is sometimes
provided by lending from the central bank to troubled institutions,
and is often referred to as the lender-of-last-resort role of the central
bank. In other cases, funds are provided directly by the government
to troubled institutions, or these institutions are taken over by the
government and the government then guarantees that depositors will
receive their money in full.
Although a government safety net can be quite successful at

protecting depositors and preventing bank panics, it is a mixed
blessing. The most serious drawback of a safety net stems from
moral hazard which arises because depositors expect that they will
not suffer losses if a bank fails. Thus, depositors are less likely to
impose the discipline of the marketplace on banks by withdrawing
deposits when they suspect that the bank is taking on too much risk.
Consequently, banks that are provided with a safety net have incen-
tives to take on greater risks than they otherwise would. The
existence of a government safety net thus creates even more reason
for governments to impose regulations to restrict risk taking by
financial institutions.
Furthermore, not only are government regulations needed to

restrict risk taking, but supervision is required as well. Not surpris-
ingly, banks are the most closely supervised institutions in the
economy. Regular bank examinations, which allow regulatory
authorities to monitor whether the bank is complying with capital
requirements and restrictions on asset holdings, also function to limit
moral hazard. In addition, bank examiners can assess whether the
bank has the proper management controls in place to prevent fraud
or excessive risk taking. With this information about a bank’s
activities, bank examiners can enforce capital requirements and
force a bank to revise its management practices if these practices are
jeopardizing the safety and soundness of the bank.
This brief survey shows that information problems are a central

feature of financial systems and explains why financial systems are
structured the way they are. These same informational problems
explain why financial instability occurs as we will see below.
The causes of financial instability
Financial instability occurs when shocks to the financial system

interfere with information flows so that the financial system can no
longer do its job of channeling funds to those with productive
investment opportunities. Without access to these funds, individuals
and firms cut their spending, resulting in a contraction of economic
activity, which can sometimes be quite severe. In order to prevent
financial instability from occurring, policymakers need to under-
stand what causes it to happen. The asymmetric information analysis
we have used to understand the structure of the financial system

suggests that there are four categories of factors that lead to financial
instability: increases in interest rates, increases in uncertainty, asset
market effects on balance sheets, and problems in the banking sector.
Increases in interest rates
As demonstrated by Stiglitz and Weiss (1981), asymmetric infor-

mation and the resulting adverse selection problem can lead to credit
rationing in which some borrowers are denied loans even when they
are willing to pay a higher interest rate. This occurs because indi-
viduals and firms with the riskiest investment projects are exactly
those who are willing to pay the highest interest rates since if the
high-risk investment succeeds, they will be the main beneficiaries.
Thus, a higher interest rate leads to even greater adverse selection;
that is, the higher interest rate increases the likelihood that the lender
is lending to a bad credit risk. If the lender cannot discriminate
among the borrowers with the riskier investment projects, it may
want to cut down the number of loans it makes, which causes the
supply of loans to decrease with the higher interest rate, rather than
increase. Thus, even if there is an excess demand for loans, a higher
interest rate will not be able to equilibrate the market because
additional increases in the interest rate will only decrease the supply
of loans and make the excess demand for loans increase even further.
The theory behind credit rationing can be used to show that

increases in interest rates can be one factor that helps precipitate
financial instability. If market interest rates are driven up sufficien-
tly, there is a higher probability that lenders will lend to bad credit
risks, those with the riskiest investment projects, because good
credit risks are less likely to want to borrow while bad credit risks
are still willing to borrow. Because of the resulting increase in
adverse selection, lenders will want to make fewer loans, possibly
leading to a steep decline in lending that will lead to a substantial
decline in investment and aggregate economic activity. Indeed,
theoretically, a small rise in the riskless interest rate can sometimes
lead to a very large decrease in lending and even a possible collapse
in the loan market.6
Increases in uncertainty
A dramatic increase in uncertainty in financial markets, due per-

haps to the failure of a prominent financial or nonfinancial institution,
a recession, political instability, or a stock market crash, makes it
harder for lenders to screen out good from bad credit risks. The
increase in uncertainty, therefore, makes information in the financial
markets even more asymmetric and may worsen the adverse selec-
tion problem. The resulting inability of lenders to solve the adverse
selection problem renders them less willing to lend, leading to a
decline in lending, investment, and aggregate activity.
Asset market effects on balance sheets
The state of the balance sheet of both nonfinancial firms and banks
is the most critical factor for the severity of asymmetric information
problems in the financial system. Deterioration of balance sheets
worsens both adverse selection and moral hazard problems in finan-
cial markets, thus promoting financial instability.
An important way that financial markets can solve asymmetric

information problems is with the use of collateral. Collateral reduces
the consequences of adverse selection or moral hazard because it
reduces the lender’s losses in the case of a default. If a borrower
defaults on a loan, the lender can take title and sell the collateral to
make up for the losses on the loan. Thus, if the collateral is of good
enough quality, the fact that there is asymmetric information between
borrower and lender is no longer as important since the loss incurred
by the lender if the loan defaults is substantially reduced.
Net worth performs a similar role to collateral. If a firm has high

net worth, even if it defaults on its debt payments as a result of poor
investments, the lender can take title to the firm’s net worth, sell it
off, and use the proceeds to recoup some of the losses from the loan.
In addition, the more net worth a firm has in the first place, the less
likely it is to default because the firm has a cushion of assets that it
can use to pay off its loans. High net worth also directly decreases
the incentives for borrowers to commit moral hazard because
borrowers now have more at stake, and thus more to lose, if they
default on their loans. Hence, when firms seeking credit have high
net worth, the consequences of adverse selection and moral hazard
are less important and lenders will be more willing to make loans.
Stock market crashes have an important role to play in promoting

financial instability through the net worth effects on adverse selec-
tion and moral hazard problems described above. As emphasized by
Greenwald and Stiglitz (1988), Bernanke and Gertler (1989), and
Calomiris and Hubbard (1990), a sharp decline in the stock market,
as in a stock market crash, can increase adverse selection and moral
hazard problems in financial markets because it leads to a large
decline in the market value of firms’ net worth. (Note that this
decline in asset values could occur either because of expectations of
lower future income streams from these assets or because of a rise
in market interest rates that lowers the present discounted value of
future income streams.) 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 firms has a similar role to collateral, and
when the value of collateral declines, it provides less protection to
lenders so that losses from loans are likely to be more severe. In
addition, the decline in corporate net worth as a result of a stock
market decline increases moral hazard incentives for borrowing
firms to make risky investments because these firms now have less
to lose if their investments go sour. Because borrowers have increased
incentives to engage in moral hazard and because lenders are now
less protected against the consequences of adverse selection, the
stock market decline leads to decreased lending and a decline in
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 financial instability through both
firms’ and households’ balance sheets. As pointed out in Bernanke
and Gertler’s (1995) excellent survey of the credit view of monetary
transmission, a rise in interest rates and therefore in households’ and
firms’ interest payments, decreases firms’ cash flow, which causes
a deterioration in their balance sheets.7 As a result, adverse selection
and moral hazard problems become more severe for potential lend-
ers to these firms and households, leading to a decline in lending
and economic activity. There is thus an additional reason why sharp
increases in interest rates can be an important factor leading to
financial instability.
In economies in which inflation has been moderate, which char-

acterizes most industrialized countries, many debt contracts are
typically of fairly long duration. In this institutional environment,
an unanticipated decline in inflation leads to a decrease in the net
worth of firms. Debt contracts with long duration have interest
payments fixed in nominal terms for a substantial period of time,
with the fixed interest rate allowing for expected inflation. When
inflation turns out to be less than anticipated, which can occur either
because of an unanticipated disinflation as occurred in the United
States in the early 1980s or by an outright deflation as frequently
occurred before World War II in the United States, the value of firms’
liabilities in real terms rises so that there is an increased burden of
the debt, but there is no corresponding rise in the real value of firms’
assets. The result is that net worth in real terms declines. A sharp
unanticipated disinflation or deflation, therefore, causes a substantial
decline in real net worth and an increase in adverse selection and
moral hazard problems facing lenders. The resulting increase in adverse
selection and moral hazard problems (of the same type that were
discussed in assessing the effect of net worth declines earlier) will thus
also work to cause a decline in investment and economic activity.
In contrast to the industrialized countries, many emerging-market

countries have experienced very high and variable inflation rates,
with the result that debt contracts are of very short duration. For
example, in many emerging-market countries, almost all bank lend-
ing is with variable rate contracts that are usually adjusted on a
monthly basis. With this institutional framework, a decline in unan-
ticipated inflation does not have the unfavorable direct effect on
firms’ balance sheets that it has in industrialized countries. The short
duration of the debt contracts means that there is almost no change
in the burden of the debt when inflation falls because the terms of
the debt contract are continually repriced to reflect expectations of
inflation. Thus, one mechanism that has played a role in low-infla-

tion countries to promote financial instability has no role in many
emerging-market countries that have experienced high and variable
inflation.8
On the other hand, there is another factor affecting balance sheets

that can be extremely important in precipitating financial instability
in emerging-market countries that is not operational in most indus-
trialized countries: unanticipated exchange rate depreciation or
devaluation. Because of uncertainty about the future value of the
domestic currency, many nonfinancial firms, banks, and govern-
ments in emerging-market countries find it much easier to issue debt
if the debt is denominated in foreign currencies. A substantial
amount of debt denominated in foreign currency was a prominent
feature of the institutional structure in Chilean financial markets
before its financial crisis in 1982 and in Mexico in 1994. With this
institutional structure, unanticipated depreciation or devaluation of
the domestic currency is another factor that can lead to financial
instability in emerging-market countries and it operates in a similar
fashion to an unanticipated decline in inflation in industrialized
countries. With debt contracts denominated in foreign currency,
when there is an unanticipated depreciation or devaluation 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 decline in
net worth, which then increases adverse selection and moral hazard
problems along the lines described above. The increase in asymmet-
ric information problems leads to a decline in investment and
economic activity.
Problems in the banking sector
As we have seen, banks have a very important role in financial

markets since they are well-suited to engage in information-producing
activities that facilitate productive investment for the economy.
Thus, a decline in the ability of banks to engage in financial inter-
mediation and make loans will lead directly to a decline in investment
and aggregate economic activity.
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 have two
choices: either they can cut back on their lending in order to shrink
their asset base and thereby restore their capital ratios, or they can
try to raise new capital. However, when banks experience a deterio-
ration in their balance sheets, it is very hard for them to raise new
capital at a reasonable cost. Thus, the typical response of banks with
weakened balance sheets is a contraction in their lending, which
slows economic activity. Research suggests, for example, that this
mechanism was operational during the early 1990s in the United
States when the capital crunch led to the head winds which hindered
growth in the U.S. economy at that time.9
Negative shocks to banks’ balance sheets can take several forms.

We have already seen how increases in interest rates, stock market
crashes, an unanticipated decline in inflation (for industrialized
countries), or an unanticipated depreciation or devaluation (for
emerging-market countries with debt denominated in foreign cur-
rencies), can cause a deterioration in nonfinancial firms’ balance
sheets that reduces the likelihood of their repaying their loans. Thus,
these factors can help precipitate sharp increases in loan losses that
increase the probability of bank insolvency.
Increases in interest rates can also have an even more direct

negative effect on bank balance sheets. Because banks often are
engaged in the traditional banking business of “borrowing short and
lending long,” they typically have a maturity mismatch with longer
duration assets than liabilities. Thus, a rise in interest rates directly
causes a decline in net worth because the interest-rate rise lowers
the value of assets with their longer duration more than it raises the
value of liabilities with their shorter duration. Therefore, even if the
credit quality of bank loans were to remain unaffected, a rise in
interest rates causes a decline in net worth that then leads to a decline
in bank lending.
Banks in emerging-market countries face additional potential

shocks that can make financial instability more likely. For example,
because emerging-market countries are often primary goods produc-

ers, they are frequently subject to large terms-of-trade shocks that
can devastate banks’ balance sheets whose assets are composed
primarily of loans to domestic firms. The lack of asset diversifica-
tion outside their country can thus be a severe problem for banks in
emerging-market countries that is not present for many banking
institutions in industrialized countries which do have the ability to
diversify their assets across countries.10
Also banks in many emerging-market countries raise funds with

liabilities that are denominated in foreign currencies. A depreciation
or devaluation of the domestic currency can thus lead to increased
indebtedness, while the value of the banks’ assets do not rise.11 The
resulting deterioration in banks’ equity capital can lead to substantial
declines in bank lending because the resulting drop in bank capital
results in a failure of banks to meet capital standards, such as the
Basle requirements. The decline in bank capital then requires banks
to shrink their lending until they can raise new capital to meet the
capital standards.
Weak bank balance sheets can also occur because the supervi-
sory/regulatory structure has not worked well enough to restrain
excessive risk taking on the part of banks. There are two reasons
why the regulatory process might not work as intended. The first is
that regulators and bank managers may not have sufficient resources
or knowledge to do their jobs properly. This commonly occurs after
a financial liberalization in which banking institutions are given new
lending opportunities. Not only do the managers of banking institu-
tions frequently not have the required expertise to manage risk
appropriately in these new lines of business, but also they lack the
managerial capital to cope with the rapid growth of lending that
typically follows a financial liberalization. Even if the required
managerial expertise were available initially, the rapid credit growth
is likely to outstrip the available information resources of the bank-
ing institution, resulting in excessive risk taking.
Not only do the new lines of business and rapid credit growth
stretch the managerial resources of banks, but also they similarly
stretch the resources of bank supervisors. After a financial liberali-

zation, bank supervisors frequently find themselves without either
the expertise or the additional resources needed to appropriately
monitor banks’ new lending activities. The result of insufficient
resources and expertise both in banks and in their supervisory
institutions is that banks take on excessive risks, leading to large
loan losses and a subsequent deterioration in their balance sheets.
The second reason why the regulatory process might not work as
intended is explained by recognizing that the relationship between
voters-taxpayers on the one hand and the regulators and politicians
on the other creates a particular type of moral hazard problem, the
principal-agent problem. The principal-agent problem occurs when
agents have different incentives from the person they work for (the
principal) and so act in their own interest rather than in the interest
of their employer. Regulators and politicians are ultimately agents
for voters-taxpayers (principals) because in the final analysis tax-
payers bear the cost of any losses when the safety net is invoked.
The principal-agent problem occurs because the agent (a politician
or regulator) may not have the same incentives to minimize costs to
the economy as the principal (the taxpayer).
To act in the taxpayer’s interest, regulators have several tasks, as

we have seen. They must set restrictions on holding assets that are
too risky, impose sufficiently high capital requirements, and close
down insolvent institutions. However, because of the principal-
agent problem, regulators have incentives to do the opposite and
engage in regulatory forbearance. One important incentive for regu-
lators that explains this phenomenon is their desire to escape blame
for poor performance by their agency. By loosening capital require-
ments and pursuing regulatory forbearance, regulators can hide the
problem of an insolvent bank and hope that the situation will
improve.12 Another important incentive for regulators is that they
may want to protect their careers by acceding to pressures from the
people who strongly influence their careers, the politicians. Regu-
latory agencies that have little independence from the political
process are therefore more vulnerable to these pressures.
Deterioration in bank balance sheets can occur either because of

excessive risk taking on the part of banks as a result of inadequate
bank regulation and supervision or because of negative shocks such
as interest-rate rises, stock market crashes, an unanticipated decline
in inflation (for industrialized countries), or an unanticipated depre-
ciation or devaluation (for emerging-market countries with debt
denominated in foreign currencies). If the deterioration in bank
balance sheets is severe enough, however, it can have even more
drastic effects on bank lending if it leads to bank panics, in which
there are multiple, simultaneous failures of banking institutions.
Indeed, there is some possibility that, in the absence of a govern-

ment safety net, contagion can spread from one bank failure to
another, causing even healthy banks to fail. The source of the
contagion is again asymmetric information. In a panic, depositors,
fearing the safety of their deposits and not knowing the quality of
the banks’ loan portfolios, withdraw their deposits from the banking
system, causing a contraction in loans and a multiple contraction in
deposits, which then causes other banks to fail.
The disappearance 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 a direct loss of financial intermediation that can be done
by the banking sector. The outcome is an even sharper decline in
lending to facilitate productive investments, with a resulting sharp
contraction in economic activity. Another negative effect on the
economy occurs through the effect of a banking panic on the money
supply. Because a banking panic also results in a movement from
deposits to currency, the usual money-multiplier analysis indicates
that the money supply will fall. The resulting decline in the money
supply then leads to higher interest rates, which, as we have seen,
increases adverse selection and moral hazard problems in financial
markets and causes a further contraction in economic activity.
Propagation of financial instability
Now that we have examined the factors that cause financial

instability, we can see how they interact to propagate this condition.
Indeed in extreme cases, these factors can interact to produce a

financial crisis, an even stronger form of financial instability in
which the financial system seizes up abruptly and almost stops
functioning.
There are two major institutional differences in the financial

markets of industrialized countries versus emerging-market coun-
tries that imply different propagation mechanisms for financial
instability. As mentioned earlier, in industrialized countries where
inflation typically has been low and not very variable, many debt
contracts are of long duration. Furthermore, because these industri-
alized countries typically retain a strong currency, most debt con-
tracts are denominated in the domestic currency. In contrast, many
emerging-market countries have had high and variable inflation
rates in the past and so, long-term debt contracts are too risky. The
result has been a debt structure of very short duration. Given poor
inflation performance, these countries also have domestic currencies
that undergo substantial fluctuations in value and are thus very risky.
To avoid this risk, many debt contracts in these countries are
denominated in foreign currencies.
Clearly the dichotomy that emerging-market countries have

short-duration debt contracts that are frequently denominated in
foreign currency while industrialized countries have longer-duration
debt contracts that are denominated in domestic currency is too
strong. Some industrialized countries have had a substantial amount
of debt denominated in foreign currency. (This was the case in the
Nordic countries, for example.) The distinction between industrialized
countries and emerging-market countries in terms of the institu-
tional structure of their financial system is thus not completely clear
cut: some industrialized countries have attributes of their financial
structure that are typical of emerging-market countries and vice
versa. Nonetheless, this dichotomy is a useful one.
These two different types of institutional structures lead to differ-

ent propagation mechanisms for financial instability. Figure 1 describes
the propagation mechanisms for “industrialized countries,” while
Figure 2 describes the mechanisms for “emerging-market coun-
tries.” The factors causing financial instability are surrounded by

ovals, whereas the effects of these factors are surrounded by boxes.
The dashed lines show the propagation of financial instability.
The initial impetus for financial instability is the same for both
industrialized countries and emerging-market countries as the first
row of Figures 1 and 2 indicates. Four factors typically help initiate
financial instability: (1) increases in interest rates, (2) a deterioration
in bank balance sheets, (3) negative shocks to nonbank balance
sheets such as a stock market decline, and (4) increases in uncer-
tainty. Countries often begin experiencing major bouts of financial
instability when domestic interest rates begin to rise, often with the
rise initiated by interest rate increases abroad. For example, as
documented in Mishkin (1991), most financial crises in the United
States in the nineteenth and early twentieth centuries began with a
sharp rise in interest rates that followed interest rate increases in the
London markets. Similarly, the Mexican financial crisis of 1994-95
began with upward pressure on domestic interest rates following the
monetary tightening in the United States beginning in February
1994. As we have seen, these rises in interest rates increased adverse
selection problems in the credit markets. The rise in interest rates
also increased moral hazard problems because the resulting decrease
in cash flow hurt the balance sheets of nonbank firms. In addition,
the increase in interest rates weakened bank balance sheets because
of banks’ maturity mismatch and also led to increased moral hazard
problems as indicated in the next row in Figures 1 and 2.
Also characteristic of the early stages of financial instability is a

deterioration in bank balance sheets because of risky loans that have
turned sour. In the recent Mexican episode, the source of these
weakened balance sheets was financial liberalization that led to a
rapid acceleration of bank lending, in which bank credit to the
private nonfinancial business sector rose from 10 percent of GDP in
1988 to over 40 percent in 1994. This lending boom, which stressed
the screening and monitoring facilities of the Mexican banks, along
with the inability of the National Banking Commission in Mexico
to adequately supervise these new lending activities, led to growing
loan losses in the banking sector. The story in Japan leading up to
Figure 1
Propagation of Financial Instability
in Industrialized Countries
Increase in Deterioration in Stock market Increase in

interest rates banks’ balance decline uncertainty
sheets
Adverse selection and moral

hazard problems worsen
Economic activity
declines
Typical
financial
Banking crisis crisis

Economic activity
declines
Unanticipated
decline in
price levels

Debt
hazard problems worsen deflation
Economic activity
Factors Causing declines
Financial Instability
Effects of Factors
Economic activity
declines
Figure 2
Propagation of Financial Instability
in Emerging-Market Countries
Increase in Deterioration in Stock market Increase in

interest rates banks’ balance decline uncertainty
sheets

Foreign exchange
crisis

Economic activity
declines
Banking crisis

Factors Causing Economic activity

Financial Instability
declines
Effects of Factors
Economic activity
declines
the financial instability that country has been experiencing in the

1990s is a similar one. Liberalization of the financial sector and an
increased competitive environment for banks led to accumulating
loan losses, while a further blow was dealt to bank balance sheets
when the stock market decline reduced the banks’ hidden reserves.
The deterioration in bank balance sheets decreased the ability of the
banks to lend because efforts to improve their capital ratios required
retrenchment on lending.
Stock market crashes are also typically associated with financial

instability. The precipitous decline in stock prices in both Mexico
and Japan in recent years has been a precipitating factor in each
country’s financial instability. The declining net worth of nonfinan-
cial firms then increased adverse selection and moral hazard prob-
lems in financial markets because the effective collateral in the firms
had decreased, while the decline in net worth meant that the incen-
tives for borrowers to take on risk at the expense of the lender had
increased.
The fourth factor that frequently appears when there is financial

instability is an increase in uncertainty, whether because an econ-
omy is already in recession, or because a major financial or nonfi-
nancial firm goes bankrupt, or because of increased political
instability. Financial crises in the United States in the nineteenth and
early twentieth centuries came to a head with collapses of now
infamous firms such as the Ohio Life Insurance & Trust Co. in 1857,
the Northern Pacific Railroad and Jay Cooke & Co. in 1873, Grant
& Ward in 1884, the National Cordage Co. in 1893, the Knicker-
bocker Trust Company in 1907, and the Bank of United States in
1930. In the case of the recent episode in Mexico, the increase in
uncertainty was primarily political. The Mexican economy was hit
by political shocks in 1994, specifically the Colosio assassination
and the uprising in Chiapas, which increased general uncertainty in
Mexican financial markets. Increases in uncertainty make it harder
for financial markets to process information, thereby increasing
adverse selection and moral hazard problems and causing a decline
in lending and economic activity.
If any of the four factors in the top row of the two figures occurs,
it can promote financial instability. If all of these factors occur at the
same time and are large, the situation is likely to escalate into a
full-scale financial crisis, with much greater negative effects on the
real economy.
As shown in Figure 2, in emerging-market countries, deterioration

of banks’ balance sheets, increases in foreign interest rates, and
political uncertainty can help produce a foreign exchange crisis in
which a substantial devaluation (depreciation) of the domestic currency
occurs. Particularly important (and not sufficiently appreciated) in
promoting a foreign exchange crisis is a deterioration in bank
balance sheets that can make it extremely difficult for the central
bank to defend the domestic currency. Any rise in interest rates to
keep the domestic currency from depreciating has the additional
effect of weakening the banking system further because the rise in
interest rates hurts banks’ balance sheets. This negative effect of a
rise in interest rates on banks’ balance sheets occurs because of their
maturity mismatch and their exposure to increased credit risk when
the economy deteriorates. Thus, when a speculative attack on the
currency occurs in an emerging-market country, the central bank is
caught between a rock and a hard place. If it raises interest rates
sufficiently to defend the currency, the banking system may col-
lapse. Once investors recognize that a country’s weak banking
system makes it less likely that the central bank will take the steps
to successfully defend the domestic currency, they have even greater
incentives to attack the currency because expected profits from
selling the currency have now risen. The situation described here is
exactly the one that occurred in Mexico in 1994, and the weakness
of the banking system there played a prominent role in the ensuing
collapse of the currency.
The institutional features in emerging-market countries—the

short duration of debt, the large amount of debt denominated in
foreign currency, and the lack of inflation-fighting credibility—can
interact with a foreign exchange crisis to propel the economy into a
full-fledged financial crisis, as shown in Figure 2. A sharp decline
in the value of the domestic currency can lead to a dramatic rise in
both actual and expected inflation because of direct effects and

because it weakens the credibility of the monetary authorities to
keep inflation under control. This rise in actual and expected infla-
tion combined with attempts by the central bank to keep the value
of the currency from falling further, means that interest rates can go
to sky-high levels. In the aftermath of the Mexican December 1994
devaluation, for example, domestic short-term interest rates in Mex-
ico rose to above 100 percent at an annual rate. The interaction of
the rise in interest rates with the short duration of debt then leads to
a huge increase in interest payments, with a dramatic deterioration
in households’ and firms’ cash flow. In addition, because many firms
have their debt denominated in foreign currency, the depreciation of
the domestic currency leads to an immediate, sharp increase in their
indebtedness in domestic currency terms, while the value of their
assets remains unchanged. The result of the negative shock to net
worth is another severe blow to firms’ balance sheets, causing a
dramatic increase in adverse selection and moral hazard problems,
with the negative effects on lending and economic activity shown
in Figure 2.
In contrast to the situation in emerging-market countries, the

mechanism propagating financial instability through the foreign
exchange market is not operational for most industrialized countries.
Because inflation is expected to be kept under control, a devaluation
does not lead to large increases in expected inflation and hence in
nominal interest rates. Furthermore, to the extent that interest rates
rise, the impact on cash flow and balance sheets is not nearly as
strong because debt has much longer duration. Furthermore, with
almost all debt denominated in the domestic currency, a devaluation
has little direct impact on firms’ balance sheets. Indeed, in contrast
to the situation for many emerging-market countries, an industrial-
ized country that experiences a devaluation after a foreign exchange
crisis often gets a boost to the economy because its goods become
more competitive. This explains why an industrialized country like
the United Kingdom experienced a stronger economy after the
September 1992 foreign exchange crisis, while an emerging-market
country like Mexico experienced a depression after its foreign
exchange crisis in December 1994.
The next stage in the propagation of financial instability in both

industrialized and emerging-market countries is often a worsening
banking crisis (Figures 1 and 2). The problems of households and
firms because of the decline in economic activity and deterioration
in their cash flow and balance sheets mean that they now have
trouble paying off their debts, resulting in substantial losses for
banks. In addition, a foreign exchange crisis in an emerging-market
country produces a direct negative impact on bank balance sheets.
As described earlier, the resulting currency devaluation leads to a
substantial rise in the domestic currency value of foreign-denominated
liabilities, but the often matching foreign-denominated assets typi-
cally do not rise in value because the likelihood of these loans being
paid off in full becomes quite low in the face of worsening business
conditions and the negative effect of the devaluation on the borrow-
ers’ balance sheets. Also problematic for banks in emerging-market
countries is that many of their foreign currency-denominated debt
is very short term, so that the sharp increase in the value of this debt
leads to liquidity problems for the banks because this debt needs to
be paid back.
If the government safety net is inadequate, the problems outlined

above lead to a collapse of the banking system, but in other cases
the government is able to step in to protect depositors, thereby
avoiding a banking panic. Whether the banks disappear or whether
they remain afloat but with a substantially weakened capital base,
the ability of banks to lend decreases significantly. As we have seen,
the resulting banking crisis that decreases bank lending makes
adverse selection and moral hazard problems worse in financial
markets because banks are no longer as capable of playing their
traditional financial intermediation role. Furthermore, if a banking
panic does ensue, depositors withdraw their funds from the banking
system in order to limit their losses. Through the usual money-
multiplier story, the outcome is a decline in the money supply, which
raises interest rates even further. The result of banking crises in
industrialized and emerging-market countries is thus a severe decline
in economic activity as shown in both Figures 1 and 2.
The aftermath of a financial crisis is often a sorting out of insolvent

firms from healthy firms by bankruptcy proceedings, and the same

process would occur for banks, often with the help of public and
private authorities. Once this sorting out is complete, uncertainty in
financial markets declines, the stock market undergoes a recovery,
and interest rates fall. The outcome would be a diminution in adverse
selection and moral hazard problems and the financial crisis would
subside. With the financial markets beginning to operate reasonably
well again, the stage would be set for the recovery of the economy.
However, in industrialized countries, with their long-duration debt

contracts, financial instability might propagate further through the
process which was dubbed “debt deflation” by Irving Fisher (1933).
As shown in Figure 1, the economic downturn and contraction of
the money supply resulting from a bank panic might lead to a sharp
decline in prices. With the unanticipated deflation, the recovery
process might get short-circuited. In this situation described by
Irving Fisher (1933) as a debt-deflation, the unanticipated deflation
would lead to a further deterioration in firms’ net worth because of
the increased burden of indebtedness. As we have seen, when
debt-deflation sets in, the adverse selection and moral hazard prob-
lems continued to increase. As a result, investment spending and
aggregate economic activity might remain depressed for a long time.
Indeed, debt deflations were very common in the United States in
the nineteenth and early twentieth centuries and were associated
with among the most severe economic contractions in U.S. history
in 1873, 1907, and 1930-33. Similarly, the deflation that Japan
experienced in recent years prolonged its economic malaise by
hindering the recovery of banks’ and firms’ balance sheets.
The theory of the propagation of financial instability outlined here

provides a cohesive story not only behind the sequence of events in
financial crises in industrialized countries, such as the United States
in the nineteenth and early twentieth centuries or Japan in the 1990s,
but also for emerging-market countries such as Mexico in 1994-95
or Chile in 1982.13 It shows how countries can shift dramatically
from growth to a sharp contraction in economic activity after a
financial crisis occurs. The bottom line is that the propagation of
financial instability that becomes severe enough to produce a financial
crisis leads to such a worsening of information flows in financial

markets that it produces a collapse of lending and economic activity.
Lessons for policymakers
The asymmetric information analysis of the causes and propaga-

tion of financial instability outlined in this paper is not just theoretically
interesting but has many important lessons for policymakers.
Indeed, this analysis has implications for how the bank regulatory/
supervisory process should be structured, how financial liberaliza-
tion should proceed, which exchange rate regime should be chosen,
how the lender-of-last-resort role should be conducted, and how
policymakers should take account of the interaction of price stability
with financial stability.
Bank regulation and supervision
As we have seen, banks play a particularly important role in the

financial systems of both industrialized and particularly emerging-
market countries’ financial systems, and thus problems in the banking
sector are a particularly important source of financial instability.
Indeed, we have seen that deterioration in banks’ balance sheets are
an important precursor of financial crises, especially in emerging-
market countries. There, problems in the banking sector can make a
foreign exchange crisis more likely, which in turn leads to a full-
blown financial crisis. Our asymmetric information framework
suggests that there is an important need for a government safety net
for the banking system—the key feature of which is not deposit
insurance—in order to prevent bank panics. Although a safety net is
important, it nonetheless increases the moral hazard incentives for
excessive risk taking on the part of the banks. All countries therefore
need to pay particular attention to creating and sustaining a strong
bank regulatory/supervisory system to reduce excessive risk taking
in their financial systems.
Encouraging a strong bank regulatory/supervisory system takes

several forms. First, bank regulatory/supervisory agencies need to
be provided with adequate resources to do their job effectively.
Without these resources, the bank supervisory agency will not be

able to monitor banks sufficiently in order to keep them from
engaging in inappropriately risky activities, to have the appropriate
management expertise and controls to manage risk, or to have
sufficient capital so that moral hazard incentives to take on excessive
risk are kept in check. Indeed, this inability to monitor banks
sufficiently has occurred in both industrialized countries (for exam-
ple, the savings and loan crisis in the United States) and in many
emerging-market countries (Mexico being just one recent example).
Second, accounting and disclosure requirements for financial

institutions, which are often particularly lacking in emerging-market
countries but in a number of industrialized countries as well, need
to be beefed up considerably. Without the appropriate information,
both markets and bank supervisors will not be able to adequately
monitor the banks to deter excessive risk taking.14 Proper account-
ing standards and disclosure requirements are therefore crucial to a
healthy banking system.
Third, prompt corrective action by bank supervisors will stop

undesirable bank activities and, even more importantly, not only
close down institutions that do not have sufficient net worth, but also
make sure that stockholders and managers of insolvent institutions
are appropriately punished. Prompt corrective action is particularly
important in part because it immediately prevents banks from “bet-
ting the bank” in order to restore the value of the institution, and in
part because it creates incentives for banks not to take on too much
risk in the first place, knowing that if they do so, they are more likely
to be punished.
Fourth, because prompt corrective action is so important, the bank

regulatory/supervisory agency needs sufficient independence from
the political process in order that it is not encouraged to sweep
problems under the rug and engage in regulatory forbearance. One
way to ensure against regulatory forbearance is to give the bank
supervisory role to a politically independent central bank. This has
desirable elements as pointed out in Mishkin (1991), but some
central banks might not want to have the supervisory task thrust
upon them because they worry that it might increase the likelihood
that the central bank would be politicized, thereby impinging on the
independence of the central bank. Alternatively, bank supervisory
activities could be housed in a bank regulatory authority that is
independent of the government.
Fifth, it is important to make bank supervisors accountable if they

engage in regulatory forbearance in order to improve incentives for
them to do their job properly. For example, as pointed out in Mishkin
(1997), an important but very often overlooked part of the 1991
Federal Deposit Insurance Corporation Improvement Act (FDICIA)
in the United States, which has helped make this legislation effective,
is that there is a mandatory report that the supervisory agencies must
produce if the bank failure imposes costs on the Federal Deposit
Insurance Corporation (FDIC). The resulting report is made avail-
able to any member of Congress and to the general public upon
request, and the General Accounting Office must do an annual
review of these reports. Opening up the actions of bank supervisors
to public scrutiny makes regulatory forbearance less attractive to
them, thereby reducing the principal-agent problem. In addition,
subjecting the actions of bank supervisors to public scrutiny reduces
the incentives of politicians to lean on supervisors to relax their
supervision of banks.
Financial liberalization
Deregulation and liberalization of the financial system have swept

through almost all countries in recent years. Although deregulation
and liberalization are highly desirable objectives, the asymmetric
information framework in this paper indicates that if this process is
not managed properly, it can be disastrous. If the proper bank
regulatory/supervisory structure is not in place when liberalization
comes, the appropriate constraints on risk-taking behavior will be
nonexistent. The result will be that bad loans are likely, with poten-
tially disastrous consequences for bank balance sheets at some point
in the future. In addition, before liberalization occurs, banks may
not have the expertise to make loans wisely, and so opening them
up to new lending opportunities may also lead to poor quality of the
loan portfolio. We have also seen that financial deregulation and

liberalization also often lead to a lending boom, because of both
increased opportunities for bank lending and financial deepening in
which more funds flow into the banking system. Although financial
deepening is a positive development for the economy in the long
run, in the short run the lending boom may outstrip the available
information resources in the financial system, helping to promote a
financial collapse in the future.
The dangers in financial deregulation and liberalization do not

mean that countries should not pursue a liberalization strategy. To
the contrary, financial liberalization is critical to the efficient func-
tioning of financial markets so that they can channel funds to those
with the most productive investment opportunities. Getting funds to
those with the most productive investment opportunities is espe-
cially critical to emerging-market countries because these invest-
ments can have especially high returns, thereby stimulating rapid
economic growth. Financial deregulation and liberalization thus
need to be actively pursued, but have to be managed carefully. It is
important that policymakers put in place the proper bank regulatory/
supervisory institutional structure before liberalizing their financial
systems. This means following the precepts outlined above: provid-
ing sufficient resources to bank supervisors, adopting adequate
accounting and disclosure requirements, encouraging bank supervisors
to take prompt corrective action, and insulating bank supervision
from the political process. Furthermore, policymakers may need to
pursue financial liberalization at a measured pace in order to keep a
lending boom from getting out of hand which, in turn, stresses the
capabilities of both bank management and bank supervisors. Even
though eating is essential to human health, eating too fast can lead
to an upset stomach. A similar lesson applies to the process of
financial deregulation and liberalization.
The asymmetric information framework for analyzing financial

instability also illustrates that institutional features of the financial
system besides bank regulation can be critical to how prone coun-
tries are to financial instability and to the severity of the effects on
the economy if a financial crisis occurs. The legal and judicial
systems are very important for promoting the efficient functioning

of the financial system and the inadequacies of legal systems can be
a serious problem for financial markets. If property rights are
unclear or hard to enforce, the process of financial intermediation
can be severely hampered. For example, we have seen that collateral
can be an effective mechanism to reduce adverse selection and moral
hazard problems in credit markets because it reduces the lender’s
losses in the case of a default. However, in many countries, the legal
system makes attaching collateral a costly and time-consuming
process, thereby reducing the effectiveness of collateral to solve
asymmetric information problems. Similarly, bankruptcy proce-
dures in many countries are often very cumbersome, resulting in
lengthy delays in resolving conflicting claims. Resolution of
bankruptcies in which the books of insolvent firms are opened up
and assets are redistributed can be viewed as a process to decrease
asymmetric information in the marketplace, and as we have seen
in the discussion of how financial crises end, is an important part
of the recovery process from a financial crisis. Slow resolution of
bankruptcies can therefore delay recovery from a financial crisis
because only when bankruptcies have been resolved is there
enough information in the financial system to restore it to a healthy
operation.
Choice of exchange rate regimes
One commonly used method to reduce inflation and keep it low

is for a country to peg the value of its currency to that of a large,
low-inflation country. In some cases, this strategy involves pegging
the exchange rate at a fixed value to that of the other country’s
currency so that its inflation rate will eventually gravitate to that of
the other country. In other cases, the strategy involves a crawling
peg or target in which one country’s currency is allowed to depreci-
ate at a steady rate against that of another country so that its inflation
rate can be higher than that of the country to which it is pegged.
Although adhering to a fixed or pegged exchange rate regime can

be a successful strategy for controlling inflation, the asymmetric
information analysis in this paper illustrates how dangerous this
strategy can be for an emerging-market country. This strategy is

particularly dangerous if the emerging-market country has a fragile
banking system, short-duration debt contracts, and substantial
amounts of debt denominated in foreign currencies. With a pegged
exchange rate regime, depreciation of the domestic currency when
it occurs is a highly nonlinear event because it involves a devaluation.
Because of the institutional features of debt markets in emerging-
market countries, the devaluation, if it is large enough, can precipitate
a full-scale financial crisis in which financial markets are no longer
able to move funds to those with productive investment opportunities,
thereby causing a severe economic contraction. The devaluation that
results in a rise in indebtedness leads to a sharp deterioration in
firms’ and banks’ balance sheets. In addition, we have seen that a
devaluation, particularly if it occurs in a crisis atmosphere, can
reduce confidence in the ability of the central bank to keep inflation
under control in emerging-market countries and result in a dramatic
increase in interest rates that hurts firms’ cash flow and increases
financial instability. Thus, a sufficiently large devaluation can tip
the emerging-market country into a full-scale financial crisis, with
devastating effects on the economy. Therefore, a pegged exchange
rate regime with the institutional features outlined above is like
putting the economy on a knife edge. One slip and the economy
comes crashing down. As with Humpty Dumpty, it is very hard to
quickly put the economy back together again.
The analysis in this paper does not indicate that fixing or pegging
an exchange rate should never be used to control inflation. Indeed,
countries with a past history of poor inflation performance may find
that only with a very strong commitment mechanism to an exchange
rate peg (as in a currency board) can inflation be controlled. How-
ever, the analysis does suggest that countries using this strategy to
control inflation must actively pursue policies that will promote a
healthy banking system. Furthermore, if a country has an institu-
tional structure of a fragile banking system, short-duration debt
contracts and substantial debt denominated in foreign currencies,
using an exchange rate peg to control inflation can be a very
dangerous strategy indeed.15
A flexible exchange rate regime has the advantage that movements

in the exchange rate are much less nonlinear than in a pegged
exchange rate regime. Indeed, the daily fluctuations in the exchange
rate in a flexible exchange rate regime have the advantage of making
clear to private firms, banks, and governments that there is substantial
risk involved in issuing liabilities denominated in foreign curren-
cies. Furthermore, a depreciation of the exchange rate may provide
an early warning signal to policymakers that their policies may have
to be adjusted in order to limit the potential for a financial crisis.
The lender-of-last-resort role
We have seen that a government safety net can prevent banking

panics by eliminating losses to depositors, thus relieving them of the
need to run on the bank if they are unable to verify that the bank is
healthy. One way to avoid a run or prevent a banking panic is to
provide deposit insurance that insures deposits at all banks. The
problem with deposit insurance is that it not only props up banks
that are facing systemic risk, but also insulates depositors if the risk
is completely idiosyncratic to that bank. Thus, although deposit
insurance prevents banking panics if the insurance fund has suitable
financial backing, it eliminates market discipline, even if there is
little potential systemic risk on the horizon.
An alternative method for providing a safety net is for the central

bank to stand ready to act as a lender of last resort. The traditional
recommendation for prevention of financial crises goes back to
Thornton (1802) and Bagehot (1873) who recommend that the
central bank be a lender of last resort that will lend freely during a
panic at a penalty rate. What does the asymmetric information
framework outlined here say about this traditional recommenda-
tion? Does it provide further guidance on when the central bank
needs to be ready to be a lender of last resort and how it can conduct
this role?
Some economists, particularly of the monetarist persuasion, view

financial instability very narrowly and worry about it only if it might
produce banking panics that lead to a decline in the money supply.
With this view, the lender-of-last-resort role should be a narrow one:

the central bank would only lend freely to banks when there is a
sudden desire on the part of depositors to withdraw their funds from
banks. To lend freely at other times, during what Anna Schwartz
(1986) calls “pseudo-financial crises,” will only lead to inefficiency
because firms that deserve to fail are bailed out, or because the central
bank lending results in excessive money growth that stimulates inflation.
Indeed, this position suggests that if the central bank is able to keep
monetary aggregates growing at appropriate rates, a lender-of-last-
resort role is even needed to promote the health of the economy.
Although it sees an important role for bank panics, an asymmetric

information view of financial instability does not see bank panics
as the only financial disturbances that can have serious adverse
effects on the aggregate economy. Financial instability can have
negative effects over and above those resulting from banking
panics, and analysis of such episodes as the Penn Central bank-
ruptcy in 1970 and the stock market crash in October 1987 suggest
that a financial crisis that has serious adverse consequences for the
economy can develop even if there is no threat to the banking system
(Mishkin 1991).
The asymmetric information analysis thus suggests that a lender-

of-last-resort role may be necessary to provide liquidity to nonbanking
sectors of the financial system in which asymmetric information
problems have developed. Furthermore, this analysis suggests that
financial disturbances outside the banking system in the postwar
period have had the potential to have serious adverse effects on the
aggregate economy. However, the analysis also provides support for
the monetarist position that in order to prevent severe disturbances
to the economy, it is important for the central bank to operate as the
lender of last resort to prevent banking panics.
Although a central bank’s role as a lender of last resort has the

benefit of preventing financial crises, it does have a cost. If a bank’s
depositors expect that the central bank will provide a bank with
discount loans when it gets into trouble and come to its rescue, then
they have less incentive to monitor the bank and withdraw their
deposits if the bank takes on too much risk. Thus, the lender-of-last-
resort role in itself can produce a moral hazard problem because it
can lead to expectations that encourage banks to take on too much
risk. This moral hazard problem is most severe for large banks if
they are the beneficiaries of a somewhat misnamed “too big to fail”
policy in which depositors at a large bank in trouble are protected
from any losses by a lender-of-last-resort policy, such as that used
when Continental Illinois failed in 1984 in the United States. (The
“too big to fail” policy is somewhat misnamed because, although
depositors are completely protected from losses, the bank is in fact
allowed to fail with losses to the equity holders.) Evidence in Boyd
and Gertler (1993) suggests that the cost of the “too big to fail”
policy has indeed been quite high in the United States after it was
put into force with the failure of Continental Illinois in 1984.
Similarly, the lender-of-last-resort role to prevent a financial crisis

arising outside of the banking sector may encourage other financial
institutions and borrowers from them to take on too much risk.
Knowing that the central bank will prevent a financial crisis if it
appears imminent will encourage them to protect themselves less
against systemic risks, that is, those that occur systemwide that will
trigger a lender-of-last-resort response. There is thus a tradeoff
between the moral hazard cost of the lender-of-last-resort role and
the benefits of a lender-of-last-resort role in preventing financial
crises.16
The asymmetric information view of financial crises thus does see

a danger in too liberal a use of the lender-of-last-resort activities on
the part of central banks. That there is a need to use the lender-of-
last-resort role sparingly in order to keep moral hazard from getting
out of hand argues against such intervention unless it is absolutely
necessary. The lender-of-last-resort role should, therefore, occur
very infrequently.
One problem in deciding whether to engage in the lender-of-last-

resort role is to recognize that for it to be effective, it has to be
implemented quickly. Less intervention is required the faster the
lender-of-last-resort role is implemented because once market par-
ticipants know that liquidity is being injected into the system,

uncertainty in the financial markets will decrease. Thus, the Federal
Reserve’s actions during the stock market crash of 1987 are a
textbook case of how a lender-of-last-resort role can be performed
successfully.17 The Fed’s action was immediate, with an announcement
that operated to decrease uncertainty in the marketplace. Reserves
were injected into the system, but once the crisis was over, they were
withdrawn. Not only was a financial crisis averted, but also the
inflationary consequences of this exercise of the lender-of-last-
resort role were quite small.
However, the need for the lender-of-last-resort action to be quick

does mean that central banks may not be able to wait until all the
information is in that tells them a financial crisis is about to
occur or is occurring. To wait too long to implement a lender-of-
last-resort policy could be disastrous. Thus, even though an
asymmetric information framework provides some guidance as to
when a lender-of-last-resort role should be implemented, deciding
on when to do so will necessarily be an art rather than a science.
Central bank “feel” for conditions in the financial markets that
comes from informal as well as formal signals about developments
in these markets is necessary to make the appropriate decision on
when a lender-of-last-resort role is necessary.
Price stability
As a central banker, I cannot resist harping back to a central

banker’s favorite topic which I like to refer to as the “central
banker’s mantra.” Central bankers in developed countries are often
thought of as having a fixation on the goal of price stability. Several
rationales have been posited for this goal, including the undesirable
effects of uncertainty about the future price level on business deci-
sions and hence on productivity, distortions associated with the
interaction of nominal contracts and the tax system with inflation,
and increased social conflict stemming from inflation. Not only do
public opinion surveys indicate that the public is very hostile to
inflation, but there is also mounting evidence from econometric
studies that inflation is harmful to the economy.18
The asymmetric information analysis of financial instability in

this paper provides additional reasons why price stability is so
important. As was mentioned earlier, when countries have a past
history of high inflation, debt contracts tend to have short durations
and are often denominated in foreign currencies. These features of
debt contracts lead to increased cash flow and liquidity problems for
nonfinancial firms and banks when interest rates rise or when the
domestic currency depreciates, thus increasing the fragility of the
financial system. Price stability can thus help promote financial
stability because it leads to longer duration debt contracts. In addi-
tion, achieving price stability is a necessary condition for having a
sound currency. With a sound currency, it is far easier for banks,
nonfinancial firms, and the government to raise capital with debt
denominated in domestic currency. This also reduces financial fragility.
Furthermore, countries with highly variable inflation have a credi-

bility problem that limits what policymakers can do to promote
recovery from a financial crisis. Without credibility, a central bank
in a developing country that tries to use expansionary monetary
policy to enhance the recovery from a financial crisis may do more
harm than good. Instead of shoring up weakened balance sheets, the
expansionary policy is likely to lead to rapid rises in expected
inflation and hence in interest rates, as well as to an exchange rate
depreciation, all of which we have seen cause balance sheets to
deteriorate further, thus making the financial crisis worse. Similarly,
engaging in a lender-of-last-resort rescue might backfire because it
may lead to worries about the central bank’s commitment to low
inflation. With a credible commitment to price stability, this vicious
cycle will not occur. Expansionary monetary policy and the lender-
of-last-resort role can be effectively used to shore up balance sheets
and either nip a financial crisis in the bud or promote rapid recovery
when a financial crisis occurs, as examples from U.S. history suggest.
It is often forgotten that a goal of price stability means not only

that inflation should be kept low, but also that price deflations should
be avoided. Our analysis has shown how price deflations in indus-
trialized countries can be an important factor promoting financial
instability and even lead to a prolonged financial crisis, as occurred
during the Great Depression in the United States or recently in Japan.

Thus, the prevention of financial instability suggests why central
banks must work very hard to prevent price deflations. The preven-
tion of price deflations is as important an element of the price
stability goal as prevention of inflation.19
However, just as with the worthy goal of financial liberalization,

single-minded pursuit of price stability can be dangerous. A rapid
disinflation process that leads to high real interest rates has adverse
cash flow consequences for financial institutions such as banks. If
the financial system is very fragile with already-weakened balance
sheets, the disinflation could result in severe financial instability,
resulting in depressing effects on the economy. Thus, before engag-
ing in an anti-inflation stabilization program, policymakers need to
pay particular attention to the health of their financial system,
making sure that the regulatory/supervisory process has been effec-
tive in promoting strong balance sheets for financial institutions.
Otherwise, financial institutions may not be able to safely weather
the stresses stemming from an anti-inflation stabilization program.
Successful monetary policy, therefore, requires successful regula-
tion and prudential supervision of the financial system.
An important lesson of the analysis in this paper is that price

stability and financial stability are mutually reinforcing goals. Cen-
tral bankers and other policymakers need to always keep in mind
that pursuing price stability requires the pursuit of financial stability
and vice versa. Pursuing one goal without the other can, unfortu-
nately, be highly disastrous.
Author’s Note: I thank Steve Cecchetti, Dorothy Sobol, and participants at this symposium for
their helpful comments. Any views expressed in this paper are those of the author only and not
those of the National Bureau of Economic Research, Columbia University, the Federal Reserve
Bank of New York, or the Federal Reserve System.
Endnotes
1See Roubini and Sala-i-Martin (1995) and the references therein.
2Note that asymmetric information is not the only source of the moral hazard problem. Moral
hazard can also occur because high enforcement costs might make it too costly for the lender to
prevent moral hazard even when the lender is fully informed about the borrower’s activities.
3Note that by making private loans, financial institutions cannot entirely eliminate the
free-rider problem. Knowing that a financial institution has made a loan to a particular company
reveals information to other parties that the company is more likely to be creditworthy and will
be undergoing monitoring by the financial institution. Thus some of the benefits of information
collection produced by the financial institution will accrue to others. The basic point here is that
by making private loans, financial institutions have the advantage of reducing the free-rider
problem, but they can not eliminate it entirely.
4Rojas-Suarez and Weisbrod (1994) document that banks play a more important role in the
financial systems in emerging-market countries than they do in industrialized countries.
5As pointed out in Edwards and Mishkin (1995), the traditional financial intermediation role
of banking has been in decline in both the United States and other industrialized countries
because of improved information technology which makes it easier to issue securities. Although
this suggests that the declining role of traditional banking, which has been occurring in the
industrialized countries, may eventually occur in the developing countries as well, the barriers
to information collection in developing countries are so great that the dominance of banks in
these countries will continue for the foreseeable future.
6See Mankiw (1986).
7Additional recent surveys that discuss this monetary transmission channel are Hubbard
(1995), Cecchetti (1995), and Mishkin (1996a).
8However, a decline in unanticipated inflation during periods when an anti-inflation program

is in progress in developing countries has often been associated with very high real interest rates.
Thus an unanticipated decline in inflation can negatively affect firms’ balance sheets in
developing countries through the cash flow mechanism discussed above.
9See Bernanke and Lown (1991), Berger and Udell (1994), Hancock, Laing, and Wilcox
(1995), and Peek and Rosengren (1995), and the symposium proceedings published in the
Federal Reserve Bank of New York Quarterly Review in the spring of 1993, Federal Reserve
Bank of New York (1993).
10However, even in industrialized countries, the institutional structure of the banking system
may prevent diversification, resulting in banks that are subject to terms-of-trade shocks. For
example, because banks in Texas in the early 1980s did not diversify outside their region, they
were devastated by the sharp decline in oil prices that occurred in 1986. Indeed, this terms-of-
trade shock to the Texas economy, which was very concentrated in the energy sector, resulted
in the failure of the largest banking institutions in that state.
11An important point is that even if banks have a matched portfolio of foreign-currency
denominated assets and liabilities and so appear to avoid foreign-exchange market risk, a
devaluation can nonetheless cause substantial harm to bank balance sheets. The reason is that
when a devaluation occurs, the offsetting foreign-currency denominated assets are unlikely to
be paid off in full because of the worsening business conditions and the negative effect that these
increases in the value in domestic currency terms of these foreign-currency denominated loans
have on the balance sheet of the borrowing firms. Another way of saying this is that when there
is a devaluation, the mismatch between foreign-currency denominated assets and liabilities on
borrowers’ balance sheets can lead to defaults on their loans, thereby converting a market risk
for borrowers to a credit risk for the banks that have made the foreign-currency denominated
loans.
12Kane (1989) characterizes such behavior on the part of regulators as “bureaucratic gam-
bling.”
13See Mishkin (1991, 1996b) for a description of how this analysis explains the sequence
and timing of financial crises in the United States in the nineteenth and early twentieth centuries
and Mexico in 1994-95.
14The importance of disclosure is illustrated in a recent paper, Garber and Lall (1996), which
suggests that off-balance-sheet and off-shore derivatives contracts played an important role in
the Mexican crisis.
15See Obstfeld and Rogoff (1995) for additional arguments as to why pegged exchange rate
regimes may be undesirable.
16Because in emerging-market countries central bank lending to the financial system to

expand domestic credit in the wake of a financial crisis may arouse fears of inflation spinning
out of control, the lender-of-last-resort role may be problematic in these countries (see Mishkin
(1996b)). Central bank lending may cause a rise in interest rates and a depreciation of the
exchange rate that lead to a deterioration in cash flow and balance sheets, thus hindering recovery
of the economy.
17Indeed, this example appears in my textbook, Mishkin (1998).
18Inflation, particularly at high levels, is found to be negatively associated with growth. At

lower levels, inflation is found to lower the level of economic activity, although not necessarily
the growth rate. See the survey in Anderson and Gruen (1995) and Fischer (1993), one of the
most cited papers in this literature.
19An interesting historical example of the value of preventing deflation is that of Sweden in
the 1930s, which adopted a “norm of price stabilization” after leaving the gold standard in 1931.
As a result, Sweden did not undergo the devastating deflation and financial instability experi-
enced by other countries during the Great Depression (Jonung, 1979).
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The Causes and Propagation

In the last twenty years, countries throughout the world have

Given our recent record of increased financial instability, it is no

Information and the financial system

Financial markets and institutions perform the essential function

A crucial impediment to the efficient functioning of the financial

Adverse selection is an asymmetric information problem that

will be paid back. Moral hazard occurs because a borrower has

Another concept that is very important in understanding the impedi-

More importantly, the free-rider problem makes it less likely that

The problems created by adverse selection and moral hazard, and

One important feature of financial systems is the prominent role

the benefits of monitoring and so are better equipped to prevent

Banks have particular advantages over other financial intermedi-

Asymmetric information problems also explain why, as Mayer

The existence of asymmetric information problems also explains

information through screening and monitoring, and yet not enough

Governments also impose regulations to ensure that financial

Although disclosure requirements of this type help increase the

Another role that governments play in the financial system is to

A government safety net for depositors can short circuit runs on

Deposit insurance is not the only way in which governments

Although a government safety net can be quite successful at

Furthermore, not only are government regulations needed to

This brief survey shows that information problems are a central

The causes of financial instability

Financial instability occurs when shocks to the financial system

we have used to understand the structure of the financial system

Increases in interest rates

As demonstrated by Stiglitz and Weiss (1981), asymmetric infor-

The theory behind credit rationing can be used to show that

A dramatic increase in uncertainty in financial markets, due per-

Asset market effects on balance sheets

An important way that financial markets can solve asymmetric

Net worth performs a similar role to collateral. If a firm has high

Stock market crashes have an important role to play in promoting

Although we have seen that increases in interest rates have a direct

In economies in which inflation has been moderate, which char-

In contrast to the industrialized countries, many emerging-market

inflation. Thus, one mechanism that has played a role in low-infla-

On the other hand, there is another factor affecting balance sheets

Problems in the banking sector

As we have seen, banks have a very important role in financial

The state of banks’ balance sheets has an important effect on bank

Negative shocks to banks’ balance sheets can take several forms.

Increases in interest rates can also have an even more direct

Banks in emerging-market countries face additional potential

because emerging-market countries are often primary goods produc-

Also banks in many emerging-market countries raise funds with

stretch the resources of bank supervisors. After a financial liberali-

To act in the taxpayer’s interest, regulators have several tasks, as

Deterioration in bank balance sheets can occur either because of

Indeed, there is some possibility that, in the absence of a govern-

The disappearance of a large number of banks in a short period of

Propagation of financial instability

Now that we have examined the factors that cause financial

Indeed in extreme cases, these factors can interact to produce a

There are two major institutional differences in the financial