Misblog

"The purpose of this paper [Franklin Allen, Douglas Gale, Bubbles and Crises, August 1998] is to develop a simple formal model in which intermediation by the banking sector leads to an agency problem that results in asset bubbles. Although it has been suggested by Mishkin (1997) and others that problems arising from asymmetric information in the banking system can lead to financial crises, the way in which bubbles arise and their role in crises has not been modelled. There are two main theoretical innovations in the paper:

• The phenomenon of risk shifting or asset substitution is familiar from the corporate finance and credit rationing literature (e.g., Jensen and Meckling, 1976; Stiglitz and Weiss, 1981). However, it has not so far been applied to an asset-pricing context. When investors can borrow in order to invest in pre-existing assets, risk shifting can cause risky assets to be priced above their fundamental value, creating a bubble. This bubble in turn exacerbates the crisis that follows.
• The second innovation is to explore the role of credit expansion in creating bubbles. Credit expansion interacts with risk shifting in two ways. By encouraging investors to fund risky investments at the current date, credit expansion has a contemporaneous effect on asset prices. However, the anticipation of future credit expansion can also increase the current price of assets and it turns out that this may have the greater effect on the likelihood of an eventual crisis.

...There are a number of studies which are complementary to ours. These take as their starting point problems in the financial sector and consider how spillovers to the real sector occur (see, e.g., Bernanke [as in current Fed Chairman], 1983; Bernanke and Gertler, 1989; Holmstrom and Tirole, 1997)."--Bubbles and Crises--

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• UPDATED 05/20/2009 Geithner before Senate Banking Committee:

  Paying counter parties or other potential claimants 100% on the dollar is neither required nor necessary—let's not restructure the instruments selectively, but en masse!