Bank Incentives, Economic Specialization, and Financial Crises in Emerging Economies

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1 Bank Incntvs, Economc Spcalzaton, and nancal Crss n Emrgng Economs Amar Gand a,*, Kos John b, and mma W. Snbt c a Cox School of Busnss, Southrn Mthodst Unvrsty, 6 Bshop Blvd., Dallas, TX 7575 USA b Strn School of Busnss, Nw York Unvrsty, MEC, Sut 9-90, Nw York, NY 00 USA c Robrt. Smth School of Busnss, Unvrsty of Maryland, Collg ark, MD 074 USA Abstract W modl th vulnrablty of an conomy to a fnancal crss as arsng from th ntracton of th dgr of conomc spcalzaton and bank dbt fnancng. Th probablty of a fnancal crss s shown to ncras n th dgr of conomc spcalzaton. Bank dbt fnancng has th bnfcal ffct of lowrng th dgr of conomc spcalzaton by ncrasng accss to fnancng of nvstmnt opportunts that would not hav bn fnancd du to walth constrants of ntrprnurs fnancal accss ffct. owvr, bank dbt fnancng nducs rsk-shftng ncntvs lvrag ffct. Th nt ffct on th probablty of a fnancal crss dpnds on whch of ths two ffcts domnats. W show that commonly mployd mchansms n managng fnancal crss, partcularly balouts, nduc an addtonal agncy cost by dstortng bank ncntvs to concntrat loans n spcfc sctors bank dbt concntraton ffct. W propos a tax-basd x ant soluton mchansm that smultanously nducs optmal nvstmnt and lmnats th bank dbt concntraton ffct. Implmntaton ssus and mprcal/polcy mplcatons ar also dscussd. JE Classfcaton: G5; G; G8; G34; G38; O Ky Words: Accss; Balouts; Banks; Conflcts of ntrst, nancal crss; Incntvs; vrag; Taxs * Corrspondng author. Tl: ; fax: ; -mal: [email protected] A. Gand.

2 . Introducton A sgnfcant body of ltratur has mrgd on fnancal crss n mrgng markts. Ths ltratur focuss prmarly on macro xplanatons for th onst and propagaton of a fnancal crss. or xampl, n a rcnt papr, rancs, asan and untr 00 provd vdnc that lbralzaton of mrgng fnancal markts has rsultd n th ntgraton of dvlopng countrs captal markts nto global captal markts, thrby rsultng n a hghr lklhood of fnancal crss n mrgng markts. Mor rcntly, Chn and asan 005 and Dwyr and asan 007 show that many fnancal crss nvolv bank runs rsultng from dtroratng dpostor sntmnt about th halth of th bankng ndustry. Whl ths macro xplanatons sm plausbl, thr s an mportant mssng lmnt. Invstmnt dstortons such as, xcssv rsk-takng, and nvstmnts n non-valu maxmzng pt projcts, and th dgr of conomc spcalzaton,.., whthr an conomy s spcalzd n a fw products/actvts, or s suffcntly wlldvrsfd, appar to hav had a sgnfcant rol n contrbutng to th prcptaton and propagaton of rcnt fnancal crss s, Corstt, snt, and Roubn, 999. In ths papr, w modl th vulnrablty of an conomy to a fnancal crss as arsng from th ntracton of th dgr of conomc spcalzaton and th mod of fnancng of th nvstmnt opportunts. W dfn a fnancal crss as th jont occurrnc of th low payoff stat for all frms n an conomy. Our man rsults ar as follows: rst, w Othr macro xplanatons nclud snstvty to shard macroconomc factors such as global/rgonal busnss cycls and cross markt hdgng Kodrs and rtskr, 00, currncy dvaluatons and fnancal lvrag Brs and Kosknn, 00, busnss cycls and rcssons Alln and Gal, 998; Kamnsky and Rnhart, 999, ludty shocks and lnkags among fnancal ntrmdars Alln and Gal, 000, and captal flows Radlt and Sachs, 998. Our dfnton capturs th noton of th occurrnc of a stat n whch a larg sgmnt of th corporat sctor has poor ralzd cash flows such as, n a rcsson, rflctng an nablty to pay for contnung opratons, such as trad crdtors, opratng lass, fundng pnson oblgatons tc. Our dfnton s consstnt wth th mprcal vdnc on th onst of a crss,.g., Kamnsky and Rnhart 999 documnt that most crss occur as an conomy ntrs a rcsson. Morovr, f frms hav othr fnancal oblgatons, such as bank dbt, as s typcal n many mrgng markts, ths stat s also charactrzd by th falur of banks du to a prpondranc of dfaultd loans s, Damond, 004. As w shall s latr, th ffct of th tradtonal dbt oblgatons.g., bank fnanc s to aggravat crss arsng from conomc fundamntals. Morovr, n Sctons.3. and.3., w gnralz th noton of fnancal crss to captur not only conomc spcalzaton or ndustral concntraton but also too bg to fal and uantty of output consdratons.

3 show that th probablty of a fnancal crss ncrass n th dgr of conomc spcalzaton. Scond, ntrmdatd fnancng, th most commonly avalabl sourc of fnancng n mrgng conoms, has two countrvalng ffcts on th probablty of a fnancal crss. On th on hand, bank dbt fnancng dcrass th dgr of conomc spcalzaton by ncrasng th accss to ntrmdatd fnancng for an ncrasd mnu of actvts than that would hav bn fnancd wth only ntrnal fnancng by ntrprnurs w rfr to ths as th fnancal accss ffct. On th othr hand, th form of bank fnancng dbt causs th wll-known rsk-shftng ncntvs ladng to ovrnvstmnt n rsky projcts w rfr to ths as th lvrag ffct. Th nt ffct on th probablty of a fnancal crss dpnds on whch of ths two ffcts domnats. Thrd, w xamn mchansms commonly mployd by govrnmnts n managng a fnancal crss, wth a focus on balouts dfnd as th rpaymnt of bank dbt oblgatons of th corporatons n th vnt of a fnancal crss. Although th drct ffct of balouts s to mtgat th ngatv ffct of a fnancal crss, th fact that th balouts occur only n th fnancal crss stat charactrzd by th jont falur of frms, thy provd ncntvs for banks to concntrat thr dbt fnancng n spcfc sctors w rfr to ths as th bank dbt concntraton ffct. Ths addtonal agncy cost of bank fnancng furthr offsts th fnancal accss ffct abov. nally, w propos an x ant soluton mchansm targtd toward prvnton rathr than an x post rsoluton of a fnancal crss. Our soluton mchansm conssts of two tax structurs, on for th corporat sctor, and anothr for th bankng sctor. Th corporat tax structur s dsgnd to lmnat th lvrag ffct by concavfyng th structur of aftr-tax payoffs to rsdual clamants. 3 Th bank tax structur s dsgnd to lmnat th bank dbt concntraton ffct by changng th x ant ncntvs of th bank dcson makrs. Th proposd soluton mchansm nhancs fnancal accss and mtgats ncntv dstortons, thrby mnmzs th probablty of a fnancal crss, 3 Th proposd soluton mchansm s analogous to a socal plannr or an xtrnal agncy holdng appropratly dsgnd warrants. As s wll-known, dbt wth warrants or convrtbl dbt Grn, 984 also can accomplsh concavfyng th payoff structur to rsdual clamants. Thr ar prcdnts for balouts by th U.S. govrnmnt n xchang for warrants,.g., Chryslr n 990s.

4 whr all th avalabl postv nt prsnt valu projcts ar fnancd. W also dscuss th comparatv advantags of our soluton mchansm rlatv to othrs proposd n th ltratur, such as taxs on short trm dbt nflows, and dpost nsuranc. Our papr dffrs from othr paprs on fnancal crss n svral mportant ways. Unlk paprs that dbat th dtrmnants and th x post rsoluton of a fnancal crss, w focus on an x ant soluton mchansm amd at th prvnton of a fnancal crss. W propos a novl soluton of an appropratly dsgnd tax structur that smultanously addrsss th ncntv ssus n th bankng sctor and n th corporat sctor. Banks play an mportant rol n our modl as fnancrs of projcts that othrws would not hav bn fnancd. In addton, n contrast to th ltratur s focus on xcssv dbt, currncy nstablty, and dpostor bhavor rsultng n a bank run/bankng panc 4, w tak a mor gnral vw of a fnancal crss vn n th absnc of any of ths factors. In partcular, our papr provds th root caus of a fnancal crss as arsng from th dgr of conomc spcalzaton, whch can b furthr mpactd by th mod of fnancng of nvstmnt opportunts. 5 In our framwork, wll-publczd causs of a fnancal crss, such as currncy nstablty, xcssv dbt, and bankng pancs ar factors that could aggravat th root caus. or nstanc, f a country s hghly spcalzd, vn a low lvl of dbt fnancng can rsult n a fnancal crss charactrzd as th jont falur of larg numbr of corporatons. In fact, as w latr show n Scton 4, a fnancal crss rsultng from currncy nstablty arss as a spcal cas of our gnral charactrzaton, and t hngs on th rlatonshp btwn currncy 4 S Gorton and Wnton 003 for an xcllnt survy of th ltratur on bankng pancs. Thy conclud that In fact, t dos not sm to b an xaggraton to say that most of th thortcal work on pancs has bn motvatd by th U.S. xprnc, whch has thn bn ncorrctly gnralzd. Whl thr s no sngl dfnton of a bankng panc, s Calomrs and Gorton 99 who dfn a bankng panc as an vnt n whch bank dpostors at all or many banks n th bankng systm suddnly dmand that banks convrt thr dbt clams nto cash, to such an xtnt that banks suspnd convrtblty. Also s, Alln and Gal 998 who modfy Damond and Dybvg 983 s modl so that pancs ar rlatd to th busnss cycl, rathr than unxplanabl vnts causd by sunspots. 5 In a rlatd papr, Gabax 005 draws som conclusons smlar to ours although th focus of that papr s n xplanng ral busnss cycls. argus that aggrgat shocks ar ntatd by shocks to ndvdual frms, and that whn th ndustral concntraton s hgh, ths ffct s magnfd. Thus, hgh ndustral concntraton lads to hgh conomc volatlty n hs papr, analogous to our rsult that a hgh dgr of conomc spcalzaton s assocatd wth a largr lklhood of a fnancal crss. 3

5 nstablty and th undrlyng fundamntals cash flows. In addton, n Scton 4 w argu that a dpost nsuranc schm, whl usful n prvntng a bank run and a bankng panc, dos not rmov th root caus of a fnancal crss,.., th dgr of conomc spcalzaton. That s, w focus on an altrnatv vw of th fnancal crss arsng from th asst sd of a bank balanc sht whras th xtant ltratur on bank runs and bankng pancs has focusd manly on th lablty sd of bank balanc shts. Morovr, as w show n Scton 4, unrsolvd agncy problms at th mcro.., frm or bank lvl can not only scalat nto a fnancal crss, but also srv as a channl for th propagaton of macroconomc shocks, such as a currncy shock, rsultng n a contagon among countrs lnkd through th common shock, such as thos n a currncy unon.g., Euro zon. Whl th ncntv solutons w propos n ths papr ar rathr unorthodox n th contxt of broad publc polcy ssus rgardng th prvnton and managmnt of a fnancal crss, w argu that thy ar mplmntabl and call for fxng th roof whl th sun shns. In ths sprt, w also provd a dscusson of th mplmntaton ssus of th proposd soluton mchansm. Th rmandr of th papr s organzd as follows. Scton prsnts th thortcal modl, startng wth th optmal nvstmnt polcy wth complt contractng, charactrzs th probablty of a fnancal crss undr svral altrnatv dfntons of what consttuts a fnancal crss, and analyzs th nflunc of xtrnal fnancng n th form of bank dbt fnancng on th probablty of a fnancal crss. Scton 3 prsnts our proposd soluton mchansm, amd at lmnatng bank ncntv ffcts, whl rtanng th bnfcal ffcts. Our proposd soluton mchansm achvs th mnmal probablty of a fnancal crss gvn that all th fnancally vabl projcts n th conomy ar mplmntd at maxmal nt prsnt valu. Scton 4 compars th ffcacy of th proposd soluton mchansm rlatv to altrnatv masurs proposd n th ltratur, and dscusss whthr our rsults xtnd to othr sttngs. nally, Scton 5 concluds wth mprcal and polcy mplcatons. 4

6 . Th modl To captur th ssntal ngrdnts of our basc argumnts, w modl th followng playrs: local govrnmnt, whch srvs as th socal plannr and th lndr of last rsort n th local conomy, a rprsntatv local frm n th corporat sctor, and 3 a domstc fnancal ntrmdary, such as a rprsntatv local bank. 6 rst, w start wth a smpl dscrpton of th agncy problms at th corporat lvl. W hav a thr-dat modl. At t0, th rprsntatv local frm n th corporat sctor rass captal thr from ntrnal sourcs or from xtrnal sourcs, whr avalabl for an nvstmnt to b mad at t. At t nvstmnt opportunts appar and an nvstmnt of an amount I C suffx c for corporat sctor s mad. or smplcty, w assum that th nvstmnt opportunts ar of two typs: saf nvstmnts wth zro rsk, and a choc from a mnu of possbl rsky nvstmnts that ar ndxd by a paramtr, th probablty of rcvng th hghr payoff from nvstng n a rsky nvstmnt whos payoff structur s dscrbd blow. An amount I C nvstd n th rsky projct at t producs a trmnal cash flow at t of C wth a probablty and C wth a probablty of, wth C > I C > 7 C. On th othr hand, th sam nvstmnt of I C n th saf projct at t ylds a trmnal cash flow of I C at t. At t, th cash flow from th nvstmnt s ralzd and all clams aganst th frm ar sttld, consstnt wth th tax and lgal structur n plac. W abstract from dscountng n all tm prods by assumng a rsk-nutral valuaton wth a zro rsklss ntrst rat. 6 In ntrprtng som of our rsults, t would b usful to brng n as addtonal playrs: an xtrnal lndr who holds hard currncy clams.g., n U.S. dollars on th cash flows of th rprsntatv local frm, and an xtrnal agncy, such as th World Bank or th Intrnatonal Montary und IM whch could srv as th ntrnatonal lndr of last rsort should th socal plannr b unabl to play th rol of bng th lndr of last rsort n th local conomy for xampl, du to naduat fnancal rsourcs. S gur for th ntractons among th playrs n such an augmntd modl. 7 or xpostonal as, th rsults n ths papr ar drvd usng th assumpton of thr bng just two stats, th low stat and th hgh stat. owvr, th rsults ar gnral n natur and do not dpnd on ths assumpton. S John and Snbt 99 for dtals. 5

7 A crucal fatur of our modl s that thr s ncomplt contractng on th projct chocs mad by th local frms. At t, bfor choosng btwn th saf and th rsky nvstmnts, th rprsntatv local frm s nsdrs prvatly obsrv th valu of th paramtr, th probablty of rcvng th hghr payoff f nvstng n th rsky nvstmnt. Th valu of th paramtr s not obsrvd by th outsdrs, such as th xtrnal lndrs or th xtrnal agncy. Ths prcluds any contractng that s contngnt on th valu of th paramtr. owvr, t s common knowldg that s dstrbutd unformly ovr th ntrval [0,]. Ths modlng dvc capturs th ntuton that th local frm s nsdrs hav dscrton n thr choc of nvstmnt rsk. Th ncomplt contractng ablty s a commonly usd modlng dvc n th agncy ltratur s, for xampl, Grossman and art, 986; arrs and Ravv, 989, and can gv rs to a conflct of ntrst among clamants for xampl, btwn dbt holdrs and uty holdrs rgardng nvstmnt dcsons, whch w xamn n Scton.3. Dfnton : or a gvn cut-off valu of C, 0 nvstng n th rsky nvstmnt for C, an nvstmnt polcy { C } s dfnd as C and n th saf nvstmnt for < C. mma : Whn s unformly dstrbutd ovr [0,], an nvstmnt polcy { } producs th dstrbuton of trmnal cash flows as follows: a probablty and C wth a probablty ½[- ]. roof: S Appndx A. C wth a probablty ½ [- ], I C wth Now w dscuss th objctv functon of th socal plannr that w us n our modl. On th on hand, th socal plannr wants to xtract th maxmal valu possbl from th actvts n th conomy. On th othr hand, th socal plannr wants to do ths wth mnmal xpctd costs of a fnancal crss n th conomy. Basd on ths consdratons, th socal plannr wll sk to maxmz th sum total of nt prsnt valu 6

8 from all projcts fnancd n an conomy nt of th xpctd cost of a fnancal crss. W wll spcfy th objctv functon latr aftr w charactrz th dtals of th tchnology and th probablty of a fnancal crss... Optmal nvstmnt polcy bnchmark wth complt contractng W bgn our analyss by charactrzng th optmal nvstmnt polcy of a frm wth complt contractng.., dvod of any agncy or nformaton costs. W dfn falur n th cas of a sngl frm to b th outcom C. nc, basd on mma, an nvstmnt polcy { } rsults n a probablty of falur assssd at t0 of. nancal crss arss from th jont falur of frms n an conomy, and could b costly from th standpont of a socal plannr dpndng on th svrty of fnancal crss. W charactrz latr th probablty of a fnancal crss as a functon of th xtnt to whch an conomy s spcalzd, and th mod of fnancng of th nvstmnt opportunts. Th optmal nvstmnt polcy of a frm wth complt contractng at t s dtrmnd as follows. Th rprsntatv local frm s nsdrs obsrv and choos to nvst n th rsky nvstmnt f: C I. C C That s, thy nvst n th rsky nvstmnt f t ylds a hghr prsnt valu than what thy obtan from th rsklss nvstmnt. Th lowst cut-off valu of dnotd by that satsfs th abov uaton s: I C C C C Th nvstmnt polcy n E. s uvalnt to nvstng n th rsky nvstmnt for all valus. Usng dfnton, w charactrz th optmal nvstmnt polcy wth 7

9 ncomplt contractng as nvstmnt polcy { } whr s as gvn n E.. In othr words, f wr obsrvabl and complt contractng condtonal on wr possbl nthr of whch s possbl n our modl, th socal plannr would mandat a cut-off of to th local frm for accptng rsky projcts. It follows from mma that th prsnt valu of an nvstmnt polcy { } s gvn by: V [ ] C I C C. 3 It should b notd that f an ntrprnur wth monopoly accss to a projct had suffcnt ntrnal fnancng to mplmnt th projct, th nvstmnt polcy that h would undrtak s { } and th rsultng valu uals V n E. 3. Whn xtrnal fnancng s rurd to mplmnt projcts, ncomplt contractng lads to nvstmnt dstortons and a rducton n valu. Ths hav bn rfrrd to as agncy costs. W nxt dfn n Scton. th dgr of spcalzaton for a two-frm conomy. W xpand th noton of spcalzaton to a mult-frm conomy n Scton.3... Th dgr of spcalzaton of an conomy Th nvstmnt tchnologs avalabl n an conomy ar assumd to hav th sam structur of cash flows that w dscrbd for frm projcts n Scton.. W dfn th dgr of spcalzaton of a multpl-frm conomy, n two stps, by dfnng: th corrlaton btwn any two gvn tchnologs, and th dgr of spcalzaton of an conomy as th mnmal corrlaton that xsts among all tchnologs that ar mplmntd fnancd n that conomy. t us consdr two tchnologs dnotd by a payoff of nstad of n th hgh stat and n th low stat w drop th suffx c,.., c, snc t s clar from th contxt for a gvn lvl of nvstmnt, I,. As bfor, w dnot as, th probablty of rcvng th hghr payoff.., for tchnology,,. Both and ar dstrbutd unformly ovr th ntrval 8

10 [0,]. W captur th undrlyng corrlaton n a smpl fashon n th form of a condtonal probablty. or any ralzd valus of and :. 4 W spcfy only on condtonal probablty n E. 4 snc th rmanng condtonal probablts, such as,,,,, and can b xprssd n trms of and th frm-lvl nvstmnt polcs as shown n Appndx B. r s a masur of th corrlaton btwn th two tchnologs and. 8 W can also ntrprt th paramtr as an ndx of conomc spcalzaton. Consdr an conomy whch has two tchnologs ndxd and. Snc s a masur of how closly rlatd th two tchnologs ar, a hghr valu of,.., clos to, dnots a hghr dgr of conomc spcalzaton, and a lowr valu of,.., clos to 0, dnots a lowr dgr of conomc spcalzaton. Throughout ths papr, w assum that s not contractbl. That s, -contngnt contracts cannot b wrttn. Evn though ach frm knows ts own tchnology wll, ts xprts rgardng s lmtd. owvr, banks hav ncntvs to dvlop a suffcnt dgr of xprts on. W also mak a plausbl assumpton that s not vrfabl and hnc not nforcabl n a court of law. 9 8 W us th trms corrlaton and condtonal probablty ntrchangably n th papr. In partcular, w vw a hgh valu of as a hghr condtonal probablty that both frms hav th sam payoff thr low or hgh as dnotd n E. 4, and th rlatd uatons n Appndx B. 9 Not th unobsrvabl frm-lvl nvstmnt polcs nflunc, albt to a lmtd xtnt. or xampl, othr condtonal probablts, such as,,,,, and can b xprssd n trms of and th frm-lvl nvstmnt polcs as shown n Appndx B. Snc th nvstmnt polcs of frms ar not obsrvabl, and hnc not contractbl, t follows that s also not contractbl. 9

11 Now w charactrz th dgr of conomc spcalzaton n th contxt of a multplfrm conomy. or ach conomy, w dnot on of ts tchnologs as ts basc tchnology. Th basc tchnology can b thought of as a tchnology avalabl n th smplst of conoms, such as thos that rly prmarly on natural rsourcs, toursm, or an actvty n whch th frms n th conomy hav bn hstorcally actv. or any othr projct or tchnology n th conomy, dnot as wth th basc tchnology, dfnd analogous to E. 4. th corrlaton of th tchnology W dfn mn as th mnmum of all avalabl projcts that would b fnancd f unlmtd ntrnal fnancng wr avalabl,.., f all postv NV projcts avalabl n th conomy could b fnancd wthout agncy costs. In an conomy wth a mnu of avalabl tchnologs ndxd by from lowst to hghst,.., [ mn, max ], 0 mn srvs as an ndx of th dgr of conomc spcalzaton. mn{ : V I}, 5 mn whr s th prsnt valu of th cash flows from nvstng n a projct ndxd V by as pr th optmal nvstmnt polcy { } n E.. In th contxt of mrgng conoms, th mnmum avalabl n an conomy would b strctly gratr than mn bcaus th conomy s unabl to fnanc all avalabl projcts. Evn f suffcnt xtrnal fnancng.g., xtrnal uty or xtrnal dbt wr avalabl n an conomy, snc xtrnal fnancng could nvolv agncy costs, som projcts whch would b fnancd f ntrnal fnancng wr avalabl and hnc fnancd wth zro agncy cost would not b fnancd f xtrnal fnancng s rurd s Jnsn and Mcklng, 976; Myrs, 977. t A dnot th achvd lvl of 0 Snc mplmntng addtonal projcts wth th basc tchnology or xpandng a projct usng th basc tchnology s a commonly avalabl opton n most conoms, max usually uals on. owvr, to allow for th possblty that th basc tchnology cannot b rpatd du to rgulatory constrants or tchnologcal obsolscnc, w allow to b lss than on. max 0

12 spcalzaton, whr w dfn A as th mnmum of all th projcts that ar fnancd n an conomy. In subsunt analyss, w show that A s gratr than du to thr factors: a lmtd accss to captal, b agncy costs of dbt fnancng, and c dstortd ncntvs n th bankng sctor to concntrat thr loans n spcalzd sctors. W nxt charactrz how A s an mportant factor n dtrmnng th probablty of a fnancal crss n that conomy. mn... Economc spcalzaton and th rlatv sz of ndustrs In ssnc, our dfnton of th dgr of conomc spcalzaton dnotd by n E. 4 masurs th corrlaton btwn ndustrs of an conomy. Whl ths s cntral to th propagaton of fnancal crss n our framwork, t would b usful to gnralz t to consdr th sz dstrbuton of ndustrs wthn an conomy. Th lmtng natur of our framwork can b llustratd as follows. An conomy wth GD consstng of 95% stl producton and 5% gran producton would hav th sam as an conomy wth GD consstng of 50% stl producton and 50% gran producton, vn though th formr conomy ntutvly sms to hav a much hghr dgr of conomc spcalzaton. Consuntly, ctrs parbus, both conoms hav th sam probablty of a fnancal crss s Scton.3. In Sctons.3. and.3., w gnralz th noton of a fnancal crss to consdr an ntracton btwn th rlatv sgnfcanc of ndustrs and our masur of th dgr of conomc spcalzaton. Spcfcally, w xamn how our rsults chang f w mploy th noton of too bg to fal or basd on uantty of output consdratons n plac of our currnt dfnton of all frms falng s Scton.3 for th currnt dfnton of a fnancal crss that w us. Mor spcfcally, undr th noton of too bg to fal S Scton.3.. for dtals, as wll as whn w dfn a fnancal crss basd on th uantty of output consdratons S Scton.3. for dtals, w show that th conomy wth 95% stl producton and 5% gran producton would, n fact, hav a hghr probablty of fnancal crss than an conomy wth 50% stl producton and

13 50% gran producton undr vry plausbl assumptons about paramtr valus of th undrlyng frm tchnologs..3. Charactrzng fnancal crss In ths scton, w charactrz a drct lnk btwn th dgr of conomc spcalzaton and th probablty of a fnancal crss. W dfn a fnancal crss as th jont outcom of low payoffs for all th frms also s, footnot. In an conomy wth multpl frms, th jont falur of compans s a functon of th conomc spcalzaton and fnancal structur of th conomy. W wll dmonstrat ths n two stags. In th frst stag, w analyz th mpact of conomc spcalzaton, and n th scond stag, w dmonstrat th mpact of fnancal structur on th jont falur of compans. In th followng proposton, w charactrz th probablty of fnancal crss as a functon of conomc spcalzaton and frm-lvl nvstmnt polcs. Consdr an conomy wth two frms, wth tchnologs and. As bfor, dnot as th payoff n th hgh stat and th payoff n th low stat for a gvn lvl of nvstmnt, I,. t th nvstmnt polcy of th frms b { },. roposton Economc spcalzaton and fnancal crss: Th probablty of a fnancal crss ncrass n th dgr of conomc spcalzaton, and n th rsknss of th frm-lvl nvstmnt polcs { } and { }. roof: W comput th uncondtonal x ant probablty of a fnancal crss at t0 for frm-lvl nvstmnt polcs { } and { }. As statd n Dfnton, an nvstmnt polcy { } mpls that nsdrs of frm, nvst n th rsky projct at t f, and mplmnt th saf projct othrws,.., f <, whr s th W thank an anonymous rfr for drawng our attnton to ths ssu.

14 probablty of th hgh payoff stat of th rsky projct avalabl to frm. It follows that th probablty of a fnancal crss s s Appndx B for dtals : nancal Crss. 6 Th probablty of frm havng th low payoff s s mma. owvr, th lklhood of frm havng th saf payoff of I s s mma. Ths holds tru vn whn frm has th low payoff. Th nxt trm n E. 6,.., xcluds such jont outcoms. Th fnal trm n E. 6 s th condtonal probablty of frm also havng th low payoff whn frm has th low payoff. Clarly, th probablty of a fnancal crss s ncrasng n th dgr of conomc spcalzaton for any frm-lvl nvstmnt polcs { } and { }. Smlarly, th probablty of a fnancal crss s ncrasng n th rsk of nvstmnt polcs whch n turn s dcrasng n and for a gvn. Spcfcally, whr both frms ar fully fnancd wth ntrnal uty, E. 6 can b rwrttn as: φ, 7 whr φ s th probablty of fnancal crss assssd at t0 and frms follow nvstmnt polcs{ } and { } as dfnd n E. rproducd blow 3 : I,,. 8 Altrnatvly, th probablty of a fnancal crss can b calculatd as whch uals th xprsson n E. 6 as shown n Appndx B s E. B-. 3 Not that snc nsdrs of frm, prvatly obsrv th probablty of th hgh payoff stat of a rsky projct, thr optmal nvstmnt polcy { } s nvarant to. 3

15 roposton provds th root caus of a fnancal crss as arsng from th dgr of conomc spcalzaton. owvr, th full-fldgd analyss of th mprcal prdctons of ths thory papr s lft for futur rsarch. In Scton.4, w wll show that th dgr of conomc spcalzaton s furthr mpactd by th mod of fnancng of nvstmnt opportunts. In our framwork, th wll-publczd causs of a fnancal crss, such as currncy nstablty, xcssv dbt, and dpostor bhavor assocatd wth bankng pancs ar spcal cass of our mor gnral framwork as factors that could aggravat th root caus, and thrby ncras th probablty of a fnancal crss S Scton 4 for dtals. roposton also stats that vn wthout fnanc rlatd dstortons, a fnancal crss can ars from conomc fundamntals n a country wth a hgh dgr of conomc spcalzaton. Mor gnrally, th mod of fnancng usd can affct th ndognous choc of an nvstmnt polcy, and thus nflunc th probablty of a fnancal crss. rom roposton, w know that th probablty of a fnancal crss s dtrmnd by th dgr of spcalzaton, and frm lvl nvstmnt polcs { } and { }. In partcular, whn both frms ar fnancd partly wth dbt wth promsd paymnt of at t and th rmanng wth ntrnal uty, thy wll pursu nvstmnt polcs { } and { } dfnd as follows S Appndx A for th drvaton: I,,. 9 Gvn ths nvstmnt polcs { } and { } th probablty of a fnancal crss, φ assssd at t0 s gvn by: φ. 0 4

16 Th followng proposton on th ffct of lvrag on th probablty of a fnancal crss s straghtforward. roposton Dbt and fnancal crss: Th probablty of a fnancal crss s hghr whn th frms hav dbt as compard to fnancng fully wth uty, and t s ncrasng n th dbt lvls of th frms. roof: It s asy to vrfy from Ens. 8 and 9 that < for frm,. Ths mpls that th probablty of a fnancal crss wth dbt.., E. 0 s largr than that wth uty.., E. 7. urthr, snc probablty of a fnancal crss wth dbt s ncrasng n. s dcrasng n, t s asy to vrfy that th roposton provds a lnk btwn th probablty of a fnancal crss, dbt and conomc spcalzaton. On can nfr from roposton that just havng dbt alon s not suffcnt to trggr a fnancal crss. or xampl, f an conomy wr lss spcalzd, as n a dvlopd markt, such as th Untd Stats, dbt nducd rsk shftng 4 may not lad to a hghr lklhood of a fnancal crss snc th lnkag btwn dstortd rsk ncntvs and th probablty of a fnancal crss s dampnd. 5 Intrstngly, f an conomy wr hghly spcalzd, as n an mrgng markt that spcalzs n a fw products or actvts, a rlatvly small amount of dbt can amplfy th dstortd rsk ncntvs, ladng to a hghr lklhood of a fnancal crss. In th analyss so far.., ropostons and, w mplctly assumd that whthr a projct s fnancd wth dbt or uty dos not nflunc th conomc spcalzaton.., was assumd to b ndpndnt of th mod of fnancng. Whl ths may b tru n th Mllr-Modglan world, n a world whr xtrnal fnancng ntals agncy costs, th mnu of projcts fnancd dpnd on th avalablty and th form of xtrnal fnanc. In othr words, th form of fnancng could affct not only th nvstmnt 4 Th rsk-shftng ncntvs nducd by rsky dbt hav bn wdly studd n th fnanc ltratur,.g., Jnsn and Mcklng 976, Barna, augn, and Snbt 985, Grn 984, and John

17 polcs pursud but also th dgr of spcalzaton achvabl n an conomy. If ntrprnurs n an conomy had unlmtd ntrnal fnancng avalabl, all postv nt prsnt valu projcts avalabl n th conomy would b fnancd and A uals mn. owvr, n many mrgng conoms th supply of ntrnal fnancng s lowr than th fnancng rurd to nvst n all th postv nt prsnt valu projcts avalabl n th conomy. In Scton.4, w turn to th avalablty of xtrnal fnanc n mrgng conoms. A.3.. nancal crss and too bg to fal In Scton.., w notd that an conomy wth 95% stl producton and 5% gran producton would hav th sam as an conomy wth 50% stl producton and 50% gran producton, vn though th formr conomy ntutvly has a hghr dgr of conomc spcalzaton, and ctrs parbus, both conoms hav th sam probablty of a fnancal crss. In ths Scton, w xamn th robustnss of our rsult lnkng th probablty of a fnancal crss and th dgr of conomc spcalzaton to consdr th rlatv mportanc of ndustrs n th conomy. Spcfcally, w xamn how our rsult changs f w mploy th noton of too bg to fal 6 or too mportant to fal as cntral to th propagaton of fnancal crss. Ths noton thn suprsds fnancal crss that s prdcatd on all ndustrs falng jontly. In our framwork, th falur of a sngl yt crtcal ndustry s ncssary but not suffcnt for fnancal crss. In othr words, undr 5 Ths s analogous to th varanc of a portfolo of two assts bng a functon of th corrlaton btwn thos two assts: f th corrlaton s ngatv, th varanc of th portfolo s lowr as compard to th cas whr th corrlaton s postv. 6 Thr s an xtnsv ltratur on mprcal vdnc consstnt wth a too bg to fal phnomnon. or xampl, O ara and Shaw 990 nvstgat th ffct on bank uty valus of th Comptrollr of th Currncy's announcmnt that som banks wr too bg to fal and that for thos banks total dpost nsuranc would b provdd. Usng an vnt study mthodology, th authors fnd postv walth ffcts accrung to too-bg-to-fal banks, wth corrspondng ngatv ffcts accrung to non-ncludd banks. Thy dmonstrat that th magntud of ths ffcts dffrd wth bank solvncy and sz. In a rcnt papr, nas and Unal 004 prsnt cross-sctonal mprcal vdnc from bank mrgrs that ndcats that th prmary dtrmnants of mrgr-rlatd bondholdr gans ar dvrsfcaton gans, gans assocatd wth achvng too-bg-to-fal status, and, to a lssr dgr, synrgy gans. Also s Bhattacharya 003 6

18 ths noton of too bg to fal, w would xpct that an conomy wth 95% stl producton and 5% gran producton would hav a hghr probablty of a fnancal crss rlatv to an conomy wth 50% stl producton and 50% gran producton snc stl producton s too mportant to fal for th formr conomy. Th noton of too bg to fal suggsts that n charactrzng fnancal crss n an conomy wth 95% stl producton and 5% gran producton a mor rasonabl dfnton of a fnancal crss compard to our currnt dfnton of all frms falng s smply f th stl frm fals.., gts th low payoff. 7 Wthout any loss of gnralty, w dfn th stl frm as frm and rdfn E. 6 undr th too bg to fal noton to b smply: nancal Crss. 6-A Th probablty of frm havng th low payoff s s mma and Appndx B. Snc frm s too mportant to fal, th probablty of fnancal crss undr our altrnatv dfnton s nthr dpndnt on frm nor on th corrlaton btwn frm and frm tchnologs as rflctd n th dgr of conomc spcalzaton paramtr smply bcaus frm.., gran producton frm s not at all mportant from th standpont of a fnancal crss. On could also argu that th noton of too bg to fal suggsts that n th cas of an conomy wth 50% stl producton and 50% gran producton, our currnt dfnton of a fnancal crss of both frms gttng th low payoff as shown n E. 6 s ut rasonabl snc frm.., gran producton frm s ually mportant as frm.., stl producton frm but nthr frm s mor mportant than th othr. 8 for vdnc on ggantc ponz schms that occurrd n hstory n antcpaton of partal balouts arsng from too bg to fal ggantc ponz schms, such as n ranc durng 79 and n Grat Brtan n or smplcty, w assum that all stl producton s consoldatd n a sngl frm. 8 Nvrthlss, gvn th sprt of too bg to fal, snc both frms ar ually mportant and ach s too bg at som lvl, w could also ntrprt a fnancal crss to b f thr frm has a low payoff. In ths 7

19 In summary, E. 6 charactrzs th probablty of a fnancal crss n an conomy wth 50% stl producton and 50% gran producton, whras E. 6-A charactrzs th probablty of a fnancal crss n an conomy wth 95% stl producton and 5% gran producton. By comparng th xprssons n 6 and 6-A, t s asy to s that th probablty of a fnancal crss n an conomy wth 95% stl producton s strctly hghr than th probablty of a fnancal crss n an conomy wth 50% stl producton and 50% gran producton undr th too bg to fal noton of a fnancal crss..3.. nancal Crss and Output Sz rom th socty s prspctv, fnancal crss that s prdcatd on th jont falur of ndustrs n th conomy can b vwd as an xtrm cas of that basd on th noton of too bg to fal or too mportant to fal. An altrnatv prspctv, and a varaton of jont falur of ndustrs, may b a crtcally low lvl of jont output as a bass for fnancal crss. Undr ths altrnatv prspctv both notons of too bg to fal and jont falur of ndustrs may b too rstrctv. or nstanc, n an conomy wth 50% stl producton and 50% gran producton, f th total output s suffcntly low, t could b ntrprtd as a fnancal crss dspt th fact that non of th frms s mor mportant than th othr. In such an conomy, w could charactrz a fnancal crss by a low payoff stat of thr frm whn th othr frm dos not hav a hgh payoff. Ths stats corrspond to th payoffs,i,, or I, for th two frms as shown n Appndx B. Th probablty of a fnancal crss s thn obtand by smply summng th probablts of th rspctv clls corrspondng to,i,, or I, n Appndx B and can b xprssd as: nancal Crss I I. 6-B papr, w strctly vwd 95% stl producton and 5% gran producton as a clarr cas of whch frm s mor mportant from a fnancal crss standpont. In Scton.3. w wll consdr a mor gnral dfnton of a fnancal crss basd on th total output of both frms rathr than whthr both frms hav a low payoff or f th mor mportant frm has a low payoff. 8

20 owvr, n an conomy wth 95% stl producton and 5% gran producton, fnancal crss basd on too bg to fal or for that mattr th total output consdraton s lkly to yld that th stl frm fal for thr to b a fnancal crss. Th rsultant probablty of a fnancal crss n ths conomy undr both dfntons s xprssd n E. 6-A. Intrstngly, by comparng th xprssons n 6-A and 6-B, th probablty of a fnancal crss n an conomy wth 95% stl producton s strctly hghr than th probablty of a fnancal crss n an conomy wth 50% stl producton and 50% gran producton undr both th too bg to fal and total output crtra f th dgr of conomc spcalzaton paramtr s suffcntly low as xprssd n E. 6-C blow. Not from Appndx B that E. 6-A can b xprssd as th sum of probablts n,,,i and,, and E. 6-B as th sum of probablts n,i,, or I,. Consuntly, E. 6-A mnus E. 6-B can smply b xprssd as th probablty n, mnus th probablty n I,. urthr algbrac manpulaton ylds th xprsson n E. 6-C: E.6' E.6'' 0 < cf. 0 6-C Intutvly, ths maks sns bcaus th probablty of a fnancal crss undr th total output crtra whch s most radly applcabl for an conomy wth 50% stl producton and 50% gran producton s strctly ncrasng n th dgr of conomc spcalzaton paramtr whras th probablty of a fnancal crss undr th too bg to fal whch s most radly applcabl for an conomy wth 95% stl producton and 5% gran producton s ndpndnt of th dgr of conomc spcalzaton paramtr. Consuntly, for th lattr to b hghr, th dgr of conomc spcalzaton paramtr should b suffcntly low. or xampl, f and ar /3 ach, thn nds to b lss than ½ as pr E. 6-C whch sms ut plausbl for most conoms. 9

21 In th nxt scton w turn to th avalablty of xtrnal fnanc n mrgng conoms, and spcfcally th rol of ntrmdatd fnancng such as bank fnanc..4. Rol of bank fnanc Gvn th lmtd avalablty of ntrnal fnancng n mrgng markts, many tchnologs would hav to rly on xtrnal fnancng. a orta, opz-d-slans, Shlfr, and Vshny 997, 998 documnt that countrs wth poor nvstor protcton such as, many mrgng conoms hav smallr and narrowr captal markts. Extrnal uty s also lmtd n mrgng markts for rasons such as conomc fraglty Rajan and Zngals, 998, concntratd ownrshp and th assocatd xpropraton of mnorty sharholdrs. Evn whn th local stock markts ar dvlopd, ths stocks trad much lk prfrrd stock outsdrs gt dvdnds, and do not hav any control rghts whras nsdrs hav both cash flow and control rghts. It has bn argud that n mrgng conoms dbt wth strongr crdtor rghts consttuts a mor vabl form of xtrnal fnancng,.g., art and Moor 998. Morovr, snc publc dbt markts ar also rlatvly undvlopd n ths conoms, t can b argud that bank dbt consttuts th prmary form of xtrnal fnancng n ths conoms. 9 In our modl, w assum that bank dbt fnancng s th prmary form of xtrnal fnancng. Bfor w xamn th rol of bank dbt fnancng on conomc spcalzaton, t s usful to bnchmark th dgr of spcalzaton achvabl smply from ntrnal fnancng by ntrprnurs. nt mn{ : V I, and I W }, 9 Svral paprs suggst that bank dbt offrs many advantags, such as montorng s, for xampl, Ramakrshnan and Thakor, 984; Jams, 987; Blltt, lannry and Garfnkl, 995, ludty craton Gorton and nnacch, 990, rsoluton of markt falurs trsn, 999, and nformaton producton Boyd and rscott, 986. Ths advantags, whch ar lkly to b of grat valu n mrgng markts, provd furthr support to bank dbt bng th prmary form of fnancng n mrgng markts. 0

22 whr s th prsnt valu of th cash flows from nvstng n a projct ndxd V by.., corrlaton wth basc tchnology, I s th lvl of th rurd nvstmnt, W s th walth of th ntrprnur that owns th projct and adopts optmal nvstmnt polcy { } n E.. Bank fnanc has bn crtczd as contrbutng to fnancal fraglty snc t a shortrtrm fnanc. owvr, w show that bank dbt could rduc th probablty of a fnancal crss rathr than ncras t. That s, wth th avalablty of bank fnancng to supplmnt th walth of th ntrprnurs, a largr mnu of projcts wll b fnancd and lowr dgr of spcalzaton probablty of a fnancal crss. ormally, b < nt can b achvd whch rsults n a lowr mn{ : V I, and I W B }. b whr V s th prsnt valu of th cash flows from nvstng n a projct ndxd by as pr th optmal nvstmnt polcy { } n E. 9, I s th lvl of th rurd nvstmnt, W s th avalabl walth for th ntrprnur that owns th projct wth th corrlaton wth th basc tchnology, and B s th paymnt mad by th bank to th ntrprnur n rturn for th promsd paymnt payabl at maturty t. 0 owvr, th lvrag ffct from roposton could offst th bnfcal ffct of th lowrng of th dgr of conomc spcalzaton. Th ovrall mpact of bank dbt fnancng on th probablty of fnancal crss s summarzd n roposton 3. roposton 3 nancal accss ffct, lvrag ffct, and fnancal crss Th ffct of bank dbt fnancng on φ b, th probablty of a fnancal crss s dtrmnd by th combnd ffct of two countrvalng factors; namly th fnancal accss ffct,.., accss to xtrnal fnancng for a largr mnu of projcts lowrs to b

23 such that mn < b < nt, mn s dfnd n E. 5, and nt s dfnd n E. that dcrass φ b, and th lvrag ffct gvn by roposton that ncrass φ b. roof: Th probablty of a fnancal crss wth bank fnancng, φ b obtand by changng subscrpt n E. 0 to b to mphasz bank dbt fnancng s gvn by: φb b. 3 Snc a largr mnu of projcts ar fnancd wth bank dbt fnancng, th mnmal mplmntd, fnancng, whr b dcrass from nt, th mnmal mplmntd wth only ntrnal < b nt fnancal accss ffct. owvr, as shown n roposton, th dbt nducd rsk-shftng ncntvs mply Th ovrall ffct on φ b rflcts ths two changs. < and < lvrag ffct. Now w clos th modl by spcfyng th undrlyng objctv of th socal plannr. On th on hand, th socal plannr wants to xtract th maxmal valu possbl from th actvts n th conomy. On th othr hand, th socal plannr wants to do ths wth mnmal xpctd costs of a fnancal crss n th conomy. To b spcfc, w dfn th objctv of th socal plannr as: NV socal arg max [ V I] χφ, 4 φ 0 V s obtand by substtutng n plac of n E. 3. A lowrng of du to mor proftabl projcts bng fnancd through bank captal s ntrly consstnt wth th da of comparatv advantag. That s, a country xhausts th proftabl projcts whr t has th most comparatv advantag bfor movng to th nxt st of proftabl projcts whr t has lssr of a comparatv advantag, whch should rsult n a lowrng of from th largr numbr of projcts bng fnancd through captal from th bank.

24 whr V s th prsnt valu of th cash flows from an nvstmnt polcy { } of nvstng I lvl of rurd nvstmnt n a projct ndxd by th dgr of conomc spcalzaton, φ s th probablty of a fnancal crss, and χ s th x post cost of a fnancal crss, assumd to b ndpndnt of th probablty of a fnancal crss, φ..5. Th rol of balouts In ths scton, w analyz whthr th commonly obsrvd practcs of socal plannrs managng a fnancal crss hav th dsrd ffct of rducng th xpctd cost of a fnancal crss s E. 4. Spcfcally, w analyz whthr balouts th most commonly usd mchansm hav th dsrd ffct of lowrng th probablty of a fnancal crss by ncrasng fnancal accss, or by mtgatng th ncntv problms. W dscuss th ffcacy of othr obsrvd practcs, such as dpost nsuranc, and loan guarants n Scton 4.. Our modl s gnral nough to hlp us formally captur th dbat on mplct and xplct balouts by xtrnal agncs, such as th World Bank and th Intrnatonal Montary und IM. W vw a largr rol of both xplct and mplct balouts, vn n th absnc of captal structur ssus. or xampl, f a socal plannr may not hav th ncssary fnancal rsourcs to bal out a local frm or a local bank and thr may b an mplct undrstandng that an xtrnal agncy provds th funds n th form of dvlopmntal assstanc or xplct balout packags. W ntrprt a balout as a scnaro n whch a socal plannr pays off th dbt oblgatons of th frms to th banks only n stat of fnancal crss,.., whr all th corporatons jontly fal. rms whch fal ndvdually ar not bald out. Th consunc of th jont falur rstrcton s that t dstorts bank ncntvs to concntrat thr loans n Intrnatonal rscus of countrs n fnancal dstrss by othr xtrnal agncs dat back to arly nntnth cntury s, Tabl of Bordo and Schwartz, 999. Evn n stuatons whr thr hav not bn xplct balouts s Bordo t. al., 00 for a summary of hstorcal crss, thr may hav bn xpctatons of mplct balouts whch may hav rsultd n ncntv problms, ladng to ovrnvstmnt n rsky projcts, and output rductons du to nvstmnt dstortons. nally, any organzaton corporaton or bank that s too bg to fal or njoys lmtd lablty has smlar ncntv problms. 3

25 spcfc sctors, whos prformanc s hghly corrlatd. 3 W rfr to ths addtonal ncntv ffct as th bank dbt concntraton ffct, whch ncrass b. Th lvrag ffct prssts and s potntally magnfd at th aggrgat lvl. roposton 4 charactrzs th ffct of balouts on th bank dbt concntraton. roposton 4 Bank dbt concntraton: Balouts provd ncntvs for banks to concntrat thr loans n th hghst sctor possbl,.., max. roof: W argu that banks undrtak corrlatd lndng stratgs to jontly maxmz th nt prsnt valu of thr cash flows as shown n E. 5: π π π NV banks arg max π [ ], π 5 ε [ mn, max ] B B μ μ whr π, π, π and π dnot th probablty that banks rcv th frst subscrptd amount from frm and th scond subscrptd amount from frm n lu of th promsd paymnt of and rspctvly at t. or xampl, π s th probablty that a bank rcvs from frm and from frm at t sam as th probablty of a fnancal crss, φ. Th trms B and B rprsnt th valu of th rsky dbt absnt any balouts,.., loan procds rcvd by th frms at t n xchang for thr promsd paymnts of and at t that do not nclud th balout transfrs that may occur from th socal plannr drctly to th banks n th vnt of a fnancal crss. nally, μ and μ rprsnt th x ant prc pad f any by th banks 4 at t0 n rturn for th bal out transfrs of and n th crss stat at t. 5 3 In our modl, a bank s ncntv to spcalz ts loans to a spcfc sctor arss from ts attmpt to captalz on a balout polcy focusd on th jont falur of loans. or an altrnatv argumnt for spcalzaton of bank loans basd on bank s ncntvs to montor, s Wnton In practc, ths s uvalnt to th banks rcovrng th prc thy pay for th balout from th corporatons by lowrng th loan procds to corporatons. On th othr hand, f th arrangmnt wr 4

26 Basd on E. C-6 n Appndx C, E. 5 can b smplfd to: arg max NV banks, [ mn, max ] 6 ε π μ B B μ whr π and { } and { } dnot th frm-lvl nvstmnt polcs. W nxt xamn th ncntvs of banks to concntrat dbt. NV π [ ] > 0. 7 Inualty 7 suggsts that banks hav an ncntv to concntrat th dbt to th maxmum lvl possbl.., max. Ths holds tru whthr or not balouts ar prcd farly snc μ and μ ar pad at t0 and th dcson of whthr to concntrat loans or not s takn by th banks at t. In fact vn n th cas whr th balouts ar farly prcd,.., ratonally dtrmnd takng nto account that ratonally go to max, banks do max snc any othr would rsult n a ngatv NV as pr E. 5. That s, banks smply cannot prcommt to any othr than max. such that th corporatons pad for th balout, loan procds to th corporaton would b hghr by th prc of th balout. In thr cas, E. 5 rprsnts th objctv of th banks. 5 W spcfy th most gnral charactrzaton of μ and μ to nclud all possbl cass, such as fr balouts both zro, undrprcd balouts lowr than far valu, and ratonally antcpatd balouts that tak nto account th bank dbt concntraton. Our rsults n roposton 4 ar not nfluncd by whthr or not th balouts ar prcd farly. 5

27 Consuntly, th probablty of a fnancal crss wth balouts s hghr rlatv to bank dbt fnancng wth no balouts du to th bank dbt concntraton ffct roposton 4. Corollary provds an xprsson for th probablty of a fnancal crss wth balouts. Corollary Balout-nducd fnancal crss: Th probablty of fnancal crss wth balouts s hghr than th probablty of fnancal crss wthout balouts. roof: Th probablty of a fnancal crss wth balouts s gvn by: φ b max, 8 whch s clarly gratr than φ b n E. 3. Our rsults show that although balouts play a rol n mtgatng th ngatv ffct of a fnancal crss aftr t happns, th possblty that thr may b a balout n th fnancal crss stat provds ncntvs to banks to concntrat thr loans n spcfc sctors ladng to a hghr probablty of a fnancal crss. Takng ths nto account, w propos a tax structur on bank cash flows that rtans th x post bnfts of balouts wthout th x ant ncntv dstortons. Our analyss shows that t s possbl to hav concntraton of bank loans n th absnc of othr rsks, such as currncy rsks, and unhdgd forgn xchang postons, purly from th ncntv ffcts that w modl hr. owvr, snc currncy rsk has playd a major rol n th mor rcnt fnancal crss, such as th Argntnan, Brazlan, Russan, and th Asan fnancal crss, w do consdr t n Scton 4. as a spcal cas of our modl. Spcfcally, w xamn whthr or not currncy rsk aggravats th root caus of a fnancal crss, namly th dgr of conomc spcalzaton. W also show that t s possbl basd on our argumnts to hav a fnancal crss n svral countrs at th sam tm fnancal contagon whn th countrs ar lnkd through a common shock, such as thos n a currncy unon.g., Euro zon. 6

28 3. Soluton mchansm Th probablty of a fnancal crss s ncrasng n th dgr of conomc spcalzaton as wll as th rsknss of th mplmntd nvstmnt polcs. A possbl soluton could hav bn for all frms and all banks to b fully fnancd wth uty. owvr, thr ar svral problms why such a soluton s not asy to mplmnt snc ntrnal uty s lmtd du to ntrprnural walth constrants, and xtrnal uty and xtrnal bond markts ar not wll dvlopd n many mrgng markts du to rasons such as low lvl of nvstor protcton, hgh lvls of ownrshp concntratons, and th assocatd xpropraton of mnorty sharholdrs also s Scton.4. Consuntly, bank dbt s th prmary form of xtrnal fnancng n many mrgng markts. Th soluton mchansm that w propos ams to rduc th ngatv ffcts of bank fnancng and dbt fnancng n gnral whl rtanng th postv ffcts of ncrasd xtrnal fnancng. That s, t lmnats th bank dbt concntraton ffct and th lvrag ffct, whl prsrvng th fnancal accss ffct. Wth ths nd n vw, w propos a novl tax structur that smultanously lmnats th bank dbt concntraton ffct and th rsk shftng ncntvs n th managral nvstmnt dcson lvrag ffct. Th spcfc dtals of our soluton mchansm and th ffctvnss ar prsntd blow n roposton 5. W propos a systm of progrssv taxaton for th corporat sctor to lmnat th lvrag ffct, and th bankng sctor to lmnat th bank dbt concntraton ffct. Our tax structur for th corporat sctor can b mplmntd n a mannr vry clos to th xstng schm of corporat taxaton wth th followng faturs: tax dductblty of paymnts to crdtors dnotd by, a spcfd amount of addtonal dducton,.., a tax holday, smlar to non-dbt tax shlds, such as dprcaton dnotd by λ, and 3 normal taxaton, τ of unshldd profts. Th amount of dducton allowd n,.., λ, wll b ndognously drvd as a functon of th promsd paymnt,..,, and th frms nvstmnt opportunts. Our proposd tax structur for th bankng 7

29 sctor s a tax rat t on th bank cash flows whn th banks rcv th full promsd paymnt..,,,. roposton 5 Incntv algnmnt n th corporat and bankng sctors: A tax systm charactrzd by a margnal corporat tax rat τ, and a tax dductbl τ amount λ whr τ and λ ar rlatd as follows: λ { }, lads to valu τ maxmzng nvstmnt polcs, } wth zro agncy costs n th corporat sctor. { A tax systm charactrzd by a tax rat t t bc pad by th banks only whn thy rcv th full promsd paymnt from th corporat sctor nducs banks to achv th mnmal dgr of conomc spcalzaton,.., mn. roof: W prsnt th proof n two stags. rst stag corporat sctor: Undr th spcfd tax systm frms uty-holdrs wll nvst n th rsky projct for all τ, λ, whr τ, λ s gvn by: τ, λ { τ λ } { I τ I λ }. Rarrangng th trms gvs th followng xprsson for τ, λ, I τ I λ τ, λ. 9 τ λ or th nvstmnt polcy τ, λ to b dntcal to th optmal polcy { }, st th rght-hand-sd of E. 9 to th rght-hand sd of E.. Smplfyng ylds th followng xprsson for λ. τ λ { }. 0 τ 8

30 Th tax structur τ, λ mplmnts th parto optmal nvstmnt polcy of a frm fnancd wth ntrnal uty, { }. That s, wth th proposd tax systm, th mplmntd nvstmnt polcy, λ no ncntv problms n th bankng sctor. τ. Ths should mply b mn f thr ar Scond stag bankng sctor: W know from roposton 4 that n th prsnc of balouts, banks hav an ncntv to go to th hghst possbl no mattr what b s. W lmnat th bank dbt concntraton ffct by makng th NV of banks nt of taxs to dcras rathr than ncras n. Gvn such a tax structur, th banks hav no ncntv to go to max so that loans xtndd satsfy mn b as drvd n th frst stag of ths proof. Th ntuton for ths s a hgh rsults n lowr payoffs n th hgh stat du to th tax structur forcng banks to stay at b. ormally wth th proposd tax structur n plac, π t π π NV banks arg max π [ ], π ε [ mn, max ] B B μ μ whr t s th tax rat mposd on th cash flows of th banks n th stats of th world whr thy rcvs th full promsd paymnt. Th othr trms ar as thy wr dfnd arlr n th contxt of E. 5. Basd on E. C-6 n Appndx C, E. can b smplfd to: 9

31 30, arg max max mn ], [ banks t B B NV π π μ μ ε whr π and π ar drvd n Appndx C [Ens. C- and C-4]. That s, π ; { }. π π Substtutng thm n E. ylds: { }.. arg max max mn ], [ banks t B B t NV π π μ μ ε 3 W st th tax rat, t such that NV n E. 3 s dcrasng n. Consuntly, th lowst tax rat s basd on th frst-ordr condton whr NV uals zro s: 0 ] [ t t NV bc π t bc 4

32 That s a tax-rat t such that t tbc whr t bc s dfnd n E. 4 achvs th dsrd ffct of lmnatng th dbt concntraton. Ths nsurs b mn. Our proposd soluton mchansm achvs th mnmal probablty of a fnancal crss gvn that all th fnancally vabl projcts n th conomy ar mplmntd at maxmal nt prsnt valu. Ths probablty of a fnancal crss s charactrzd n Corollary. Corollary nancal crss wth optmal nvstmnt: Undr th soluton mchansm proposd n roposton 5, nvstmnt s at th optmal lvl { }, and th rsultng probablty of fnancal crss s: φ mn mn. 5 roof: ollows from roposton 5. Gvn th conomc structur and th optmal nvstmnt polcy that allows for th fnancng of all postv nt prsnt valu projcts, E. 5 rprsnts th mnmal probablty of fnancal crss achvabl by nvstmnt polcs { }, that maxmz th valu of th undrlyng tchnologs. owvr, φ mn maxmzs th socal objctv functon n E. 4 only whn χ, th x post cost of a fnancal crss s vry low. Whn χ s postv, th socal plannr may want frms to b mor consrvatv n thr nvstmnt polcs than th valu maxmzng nvstmnt polcs { },. In ths cas, th socal plannr may provd th frms ncntvs,.g., a mor convx tax structur than that n roposton 5 to nduc such consrvatv nvstmnt polcs. Ths consrvatsm, though, coms at a cost of adoptng nfror albt, lss rsky projcts from an allocatonal standpont, and hnc could sacrfc conomc growth. Thus, th svrty and cost of fnancal crss can hampr conomc growth by makng a socal plannr tradoff btwn stablzng conomy vrsus mantanng a hghr rat of conomc growth. Ths could xplan why som conoms grow slowr than othrs, spcally thos that ar mor vulnrabl to a fnancal crss. 3

33 4. Dscusson of rsults and mplmntaton ssus In ths scton w dscuss th ffcacy of othr soluton mchansms suggstd n th ltratur. W also dscuss mplmntaton ssus rlatng to our proposd soluton. 4.. Effcacy of othr soluton mchansms W dscuss blow th mchansms adoptd by socal plannrs and/or mchansms proposd n th ltratur for managng a fnancal crss. Th common fatur of ths mchansms s to rduc th xpctd cost of fnancal crss s E. 4. W focus on thr such mchansms, namly loan guarants, dpost nsuranc, and taxs on shorttrm dbt. Spcfcally, w analyz whthr thy lowr th probablty of a fnancal crss, φ by ncrasng fnancal accss, or by mtgatng th ncntv problms oan guarants Whn a govrnmnt guarants bank loans,.., f a corporaton dfaults on ts loans to a bank, th govrnmnt maks up for th shortfall, ths could mprov th fnancal accss for th corporat sctor snc banks wll b mor wllng to lnd. Ths holds tru rrspctv of whthr or not th loan guarants ar farly prcd. Th rsultng ffct s on of potntally lowrng b du to an ncras n th supply of captal to th corporat sctor. In addton, snc loan guarants ar not prdcatd on jont falur as n balouts s Scton.5, thy should not crat any ncntvs for banks to concntrat thr dbt. owvr, th lvrag ffct outlnd n roposton rmans ntact, although t can b addrssd n a mannr smlar to th tax soluton n roposton Dpost nsuranc Whn a govrnmnt or an agncy of th govrnmnt nsurs bank dposts,.., f a bank dfaults on ts dposts, th govrnmnt maks up for th shortfall, th dpostors rcv th fac valu of th promsd paymnt. Th prmary motvaton of such a dpost nsuranc schm s to avod bank runs s, Damond and Dybvg, 983. Such 3

34 a mchansm mght b usful n prvntng a bankng crss that furthr aggravats th fnancal crss modld hr. owvr, t should b clar that a dpost nsuranc schm, such as th dral Dpost Insuranc Corporaton DIC dos not rmov th root caus of a fnancal crss,.., th dgr of conomc spcalzaton. In our framwork, w hav so far abstractd away from bank captal structur ssus. owvr, f banks fnancd thr assts loans wth dposts, and that dpost nsuranc s alrady n plac, ths could potntally mprov fnancal accss for th corporat sctor. Ths s bcaus dpost nsuranc nabls dpostors to lnd to banks wth mor confdnc and hnc ncrass th supply of funds avalabl for banks to lnd to th corporat sctor. Ths can occur whthr or not th dpost nsuranc s farly prcd. Th ncras n th supply of captal to th corporat sctor can potntally lowr Gvn th hgh lvrag of banks, and thr nvstmnt stratgy, th rsk of th loans that th banks mak would b subjct to th rsk-shftng ncntvs at th bank lvl, and also th concntraton of thr loans n spcfc sctors. Ths dstortons can b addrssd through a tax soluton as outlnd n roposton 5 S, John, John, and Snbt, 99; John, Saundrs, and Snbt, 000. b Taxaton of short-trm dbt Th ratonal for taxng short-trm dbt nflows s that t wll forc corporatons to borrow mor on th mdum and long-trm nd of th maturty structur whch ar lss vulnrabl to an mpndng crss. 6 Intutvly, proportonal taxs play a rol analogous to that of rgulatng captal. owvr, whl captal rgulaton may rduc th dbt nducd rsk-shftng ncntvs, t has lmtd ffctvnss n lmnatng ths ncntvs snc th payoff structur to th uty holdrs undr proportonal taxs s stll a convx functon of th undrlyng frm valu, albt has a lowr slop. S, John, John, and Snbt 99, and John, Saundrs, and Snbt 000 for formal proofs. 6 Damond and Rajan 00 mak an altrnatv argumnt that short-trm dbt s not th culprt for a fnancal crss but t s th ncrasng lludty of th nvstmnt bng fnancd or th dtroratng crdt ualty of borrowrs that ncsstats short-trm fnancng. Thy furthr argu that a ban on shorttrm fnancng may prcptat a mor svr crss. 33

35 4.. orgn currncy dbt and fnancal contagon In our framwork, th root caus of a fnancal crss s th dgr of conomc spcalzaton achvabl.., A, and fnancal crss rsultng from currncy nstablty arss as a spcal cas of our gnral charactrzaton, and t hngs on th rlatonshp btwn currncy nstablty and th undrlyng fundamntals cash flows. W nxt show n Corollary 3 that f th currncy rsk s postvly corrlatd wth projct rsk, frms wth forgn currncy borrowngs wll hav ncrasd ncntvs to rsk shft ladng to a hghr probablty of a fnancal crss,.., currncy rsk could xacrbat th ncntv ffcts ladng to a hghr probablty of a fnancal crss. Corollary 3 orgn currncy dbt and fnancal crss: Th probablty of a fnancal crss s hghr wth forgn currncy dbt as compard to local currncy dbt whn projct rsk and currncy rsk ar postvly corrlatd. roof: S Appndx D. A drct mplcaton of Corollary 3 s that unrsolvd agncy problms at th mcro frm or bank lvl can not only scalat nto a fnancal crss, but also srv as a channl for th propagaton of macroconomc shocks such as a currncy shock among svral countrs rsultng n a fnancal contagon, spcally among countrs lnkd through th common shock, such as thos n a currncy unon.g., Euro zon. That s, our framwork provds for a phnomnon of fnancal contagon charactrzd by: a an xognous shock, such as a sgnfcant dprcaton of th local currncy 7, ladng to a rvson n prors about xchang rat dynamcs, b an ndognous rsk-takng du to 7 In ndpndnt work, Brs and Kosknn 00 rcognz th ncntv ffcts of a currncy dvaluaton n a pggd-xchang rat nvronmnt. A currncy dvaluaton s a polcy mplmntd by th cntral govrnmnt n thr papr, lkly to b nducd by hgh lvrag. Our modl s farly gnral and dos not mpos condtons such as pggd xchang rats, rurmnt of a hgh lvrag or a potntal currncy dvaluaton bng a stratgc choc varabl for a socal plannr. In our papr, xchang rat changs could wll b rflctv of th comparatv advantag of th local conomy vrsus othr conoms n manufactur of xportng goods as prcvd by th partcpants of th forgn xchang markt. In fact, n our modl, t s possbl to hav a fnancal crss wthout a currncy crss snc th vulnrablty of a local conomy to a fnancal crss s drvn by th conomc spcalzaton, and dbt nducd rsk shftng ncntvs, and s not prdcatd on th currncy rsk. 34

36 hghr rsk-shftng ncntvs nducd by th xognous shock, and c a hgh dgr of conomc spcalzaton that can mak an conomy mor vulnrabl to a fnancal crss Implmntaton ssus Thr ar svral ntrstng ssus n mplmntng our somwhat unconvntonal soluton mchansm. In our proposal, th taxs collctd prmarly altr th structur of th payoffs to th nsdrs of th corporatons or banks, and thus lmnat th dstortons du to dbt nducd rsk-shftng ncntvs and bank dbt concntraton. In a systm wth multpl corporatons or multpl banks, th proposd tax soluton can b mplmntd on a corporaton-spcfc and bank-spcfc bass rathr than a on-sz fts all. Our soluton s analogous to th mplmntaton of th nvstmnt tax crdt ruls on an ndustry-spcfc bass, n conjuncton wth conomy-wd corporat taxaton for frms and banks as n th Untd Stats. In practc, balouts may b targtd towards loans of frms that ar too bg to fal and banks that play a ky rol n an conomy. 8 On way to mplmnt a balout polcy s to collct th prc of th balout x ant from corporatons and banks much lk an nsuranc prmum. Th socal plannr may also consdr som of th taxs collctd towards dfrayng th cost of a balout schm. owvr, t s mportant to crdbly communcat that th bank or th frm that chos not to partcpat n th balout nsuranc schm wll not b bald out x post should thr b a fnancal crss. Thus, th tradoff s a commtmnt of lss fnancal rsourcs by th socal plannr vrsus hghr admnstratv costs n dtrmnng frms that ar too bg to fal and banks that play a ky rol n an conomy n th targtd cas vs-à-vs nsurng all frms and banks. 5. Conclusons W provd a modl of ncntv ffcts whr w argu that th vulnrablty of an conomy to a fnancal crss dfnd as th jont occurrnc of th low payoff stat for 8 Th ong-trm Captal Managmnt TCM balout s on such xampl of a rcnt targtd balout. S Kho,, and Stulz 000 for vdnc on th stock prc ffcts of th TCM crss on U.S. banks. 35

37 all frms n an conomy arss from th ntracton of th dgr of conomc spcalzaton and th mod of fnancng of th nvstmnt opportunts. Th probablty of a fnancal crss ncrass n th dgr of conomc spcalzaton undr svral altrnatv dfntons of what consttuts a fnancal crss n our modl. W show that bank dbt fnancng th common sourc of fnancng n mrgng conoms has th bnfcal ffct of lowrng th dgr of conomc spcalzaton by ncrasng accss to fnancng of nvstmnt opportunts that would not hav bn fnancd du to walth constrants of ntrprnurs fnancal accss ffct. owvr, bank dbt fnancng ntroducs th wll-known dbt nducd rsk-shftng rsultng n ovrnvstmnt n rsky projcts by corporatons lvrag ffct. W analyz mchansms commonly mployd by govrnmnts n managng fnancal crss, wth a focus on balouts dfnd as th rpaymnt of bank dbt oblgatons of th corporatons n th vnt of a fnancal crss. Although th drct ffct of balouts s to mtgat th ngatv ffct of a fnancal crss, th fact that balouts ar targtd towards th fnancal crss stat, thy provd ncntvs for banks to concntrat thr dbt fnancng n spcfc sctors bank dbt concntraton ffct. Ths addtonal agncy cost of bank fnancng furthr offsts th fnancal accss ffct abov. Our soluton mchansm conssts of two tax structurs, on for th bankng sctor, and anothr for th corporat sctor, dsgnd to lmnat th bank dbt concntraton ffct, and to chang th x ant ncntvs of th rsdual clamants n th corporat sctor n th rght drcton by altrng th structur of th aftr-tax cash flows. Morovr, our soluton mchansm s vrsatl nough to handl dparturs from th optmal nvstmnt polcy, such as a consrvatv nvstmnt polcy that furthr rducs th probablty of a fnancal crss, albt at th cost of sacrfcng futur conomc growth. Th rsults of our papr provd svral mprcal and polcy mplcatons. rst, th lowr th dgr of spcalzaton of an conomy, th lss suscptbl t s to a fnancal crss. Scond, th hghr th avalablty of xtrnal fnanc, lowr s th lklhood of a fnancal crss provdd th rsk shftng ncntvs ar contand by soluton mchansm 36

38 such as th on w proposd. Thrd, hghr th xtnt of govrnmnt safty nts.g., xplct and mplct subsds or balouts, hghr th dbt concntraton of bank loans and hghr th lklhood of a fnancal crss. nally, our analyss shows that govrnmnt safty nts should b accompand by commnsurat mprovmnts n th ncntv structur. 9 A gnral mplcaton of our analyss s to hghlght th mportanc of approprat rgulatory and suprvsory nfrastructur to accompany fnancal lbralzaton. Ths s spcally n mrgng conoms wth a hgh dgr of spcalzaton bcaus rapd conomc growth and th assocatd ntrnatonal captal flows can mask thr vulnrablty to a fnancal crss. urthr, ncntv problms tnd to worsn durng a fnancal crss, but countrs wth sound fnancal systms n plac can wthstand fnancal crss 30 and fnancal contagon mor ffctvly s, Capro 998. Acknowldgmnts W thank th dtor Jams othan, an anonymous rfr, Rajsh Aggrawal, rankln Alln, Andrs Almazan, Sugato Bhattacharya, Rajsh Chakrabart, Douglas Damond, R. Gaston Glos, Robrt auswald, Davd smond, and Raghuram Rajan for hlpful commnts. An arlr vrson of th papr nttld Th Rol of Incntvs n th rvnton of nancal Crss n Emrgng Economs was prsntd at th Wstrn nanc Assocaton WA mtngs n Vancouvr, Canada, th Amrcan nanc Assocaton AA mtngs n Atlanta, Gorga, th orts-gorga Tch Confrnc on Intrnatonal nanc n Atlanta, Gorga, th nancal Managmnt Assocaton MA mtngs n Dnvr, Colorado, th McGll Unvrsty Confrnc on Challngs and Opportunts n Global Asst Managmnt, n Montral, Canada, th Indana 9 S Johnson t al 000 for vdnc that n countrs wth wak corporat govrnanc, wors conomc prospcts rsult n mor xpropraton by managrs and a largr fall n asst prcs. Also s Mtton 00, Johnson and Mtton 003, and Bak t al 004 for othr studs that xamn th lnkag btwn corporat govrnanc and frm valu. 30 Ths s consstnt wth th avalabl vdnc. In partcular, Cull, Snbt and Sorg 005 provd vdnc on th mpact of dpost nsuranc on fnancal stablty and th rsults hng on th ualty of rgulaton and rul of law. In lax rgulatory and lgal nvronmnts, th ntroducton of dpost nsuranc s countrproductv and dstablzng. owvr, n wll-rgulatd nvronmnts, dpost nsuranc has th dsrd outcom of mpactng postvly on fnancal stablty and growth. 37

39 Unvrsty s Symposum on Crss Evnts n nancal Intrmdaton and Scurts Markts, Bloomngton, Indana, th Confrnc on nancal Markt Dvlopmnt n Emrgng and Transton Economcs, n ydrabad, Inda, th IIM/ICICI Confrnc on Incntvs and Emrgng Markts n Mumba, Inda, Rutgrs Unvrsty, Unvrsty of Kansas, Unvrsty of Oklahoma, Unvrsty of South Carolna, Scurts and Exchang Commsson SEC, and Tulan Unvrsty. Appndx A roofs roof of mma Straghtforward computaton ylds th probablts assocatd wth th outcoms I C, and C as shown blow. C d I d. C C d -. C, Invstmnt polcy of a frm fnancd partly wth dbt Th uty holdrs of th rprsntatv local frm obsrv at t prvatly, and choos to nvst n th rsky nvstmnt f: Appndx B Rlatonshp btwn condtonal and uncondtonal probablts Ths Appndx shows th rlatonshp btwn condtonal and uncondtonal probablts for two tchnologs ndxd, and. Th uncondtonal probablts,, I,,, ar basd on mma. W start wth dfnng a I sngl condtonal probablty as pr E. 4 rproducd blow:. 38

40 39 W nxt show that th rmanng condtonal probablts can b drvd from and th frm-lvl nvstmnt polcs.. ; ; ; I I I I I I I I I I I I I I I I I. ; ; ; η η η η I η Sam as abov η I Sam as abov Sam as abov Sam as abov

41 η Sam abov as η W nxt show that, η, η can ach b xprssd n trms of. Ths facltats nfrncs basd on a sngl paramtr, whch w rfr to as th ndx of conomc spcalzaton. W obtan ths by solvng th followng four uatons whch rsult from uvalnc of th jont probablts basd on Bays Rul: η B- η B- η B-3 η B-4 W smplfy th abov uatons to b: η B-S B-S η η B-3S η B-4S Addng B-S and B-4S and rarrangng trms, w gt: 40

42 [ ] B-5 Clarly, s ncrasng n. Snc 0, t follows that:,. B-6 Wthout loss of gnralty, w assum that B-A such that n B-6 satsfs 0. Nxt, rarrangng B-S and substtutng B-5 ylds: [ η η ]. B-7 Agan, η s ncrasng n. Snc 0, t follows that: η,. B-8 Basd on B-A, t follows that 0 η. nally, basd on B-4S, w obtan: η η. B-9 4

43 Onc agan, η s ncrasng n. Snc 0, t follows that: η 0,. B-0 and t follows from B-A that 0 η. Appndx C Uncondtonal probablts of bank payoffs W dfn π, π, π and π as th probablty that a bank rcvs th frst subscrptd amount from frm and th scond subscrptd amount from frm n lu of th promsd paymnt of and rspctvly at t. or xampl, π s th probablty that a bank rcvs from frm and from frm at t. rom Appndx B, t should b clar that: π C- π π C- Substtutng from E. B-5 n Appndx B, and rarrangng trms ylds: 4

44 43. π π π C-3 Substtutng from E. B-7 n Appndx B, and rarrangng trms ylds: [ ] { } { } { }. π π π π C-4 It s asy to s that th four probablts n C- thru C-4 add up to on. That s,. π π π π C-5 It s to b notd that absnt any xtrnal ffcts, such as balouts and taxs, th prsnt valu to th bank whch w rfr to as bas-cas s ndpndnt of. That s,

45 44 [ ]. V cas bas π π π π π C-6 Appndx D roof of Corollary 3 W xtnd our modl n Scton n two ways: Th fac valu of th dbt, $ s dnomnatd n forgn currncy say, n U.S. dollars, W assum th followng smpl dynamcs for th xchang rat procss. Th currnt xchang rat 0 can go up to or go down to whr < < 0. 3 dnots an apprcaton of th local currncy and dnots a dprcaton of th local currncy. Also assum π and - π. Dpndng on th natur of th projcts of th frms and thr xposur to forgn xchang rsk, th succss stat.., hghr payoff stat of th frm tchnology wll b corrlatd to som dgr wth a favorabl movmnt n th xchang rat. or smplcty n modlng w assum x and - x for,. Whn ] [π, x, th projct outcoms and th xchang rat outcoms ar postvly corrlatd. Th xprncs from rcnt fnancal crss suggst that th projct outcoms and th xchang rat outcoms ar postvly corrlatd. urthr, gvn our assumpton of a zro rsklss ntrst rat and th currnt 3 Th xchang rat s spcfd n unts of th local currncy that ar rurd to buy on U.S. dollar. W normalz th currnt xchang rat 0 to b.

46 45 xchang rat, t follows that th promsd paymnt n th local currncy, and n th forgn currncy, $ ar rlatd n th followng mannr: $ 0. Now th uty holdrs of frm tak nto account th dynamcs of th xchang rat and hnc th xpctd proms paymnt on thr dbt n dtrmnng thr nvstmnt polcy. Gvn that th dbt s dnomnatd n U.S. dollars, th promsd paymnt on th dbt n uvalnt local currncy n th hgh payoff stat wll b dffrnt from that n th low payoff stat. Th condtonal xpctd valu of th promsd paymnt n th hgh payoff stat wll b ] [ $ x x and n th low payoff stat wll b ] [ $ x x. Th uty holdrs of rprsntatv local frm obsrv at t prvatly, and choos to nvst n th rsky nvstmnt f: { $ } charactrzs th nvstmnt polcy of frm wth forgn currncy dbt. Whr both frms ar fnancd partly wth dbt dnomnatd n forgn currncy,.g., U.S. dollars, and th rmanng wth uty, th probablty of a fnancal crss s:. ; $ $ Dbt cy Crss nancal D- whr { $ } and { $ }, th nvstmnt polcs of frms and ar dfnd as follows s D- abov: D -. ] [ ] [ $ $ $ I I D - 3. ] [ ; ] [ $ 0 $ $ 0 $ $ $ x x x x I I

47 whr th fac valu of th dbt, $ s dbt of frm dnomnatd n a forgn currncy say, n U.S. dollars, th currnt xchang rat 0 n unts of local currncy pr U.S. dollar can go up to or go down to whr < 0 < as shown blow: whr π π. D-4 0 π and - π, x and - x for,. Usng Ens. D-3 and D-4, x > π x x < 0 < $. Ths mpls that th probablty of a fnancal crss wth forgn currncy.., E. D- s hghr than th probablty of a fnancal crss wth local currncy dbt.., E. 0. Rfrncs: Alln,., Gal, D., 998. Optmal fnancal crss. Journal of nanc 534, Alln,., Gal, D., 000. nancal contagon. Journal of oltcal Economy 08, -33. Barna, A., augn, R. A., Snbt,. W., 985. Agncy problms and fnancal contractng. rntc-all, Englwood Clffs, NJ. Bak, J. S., Kang, J. K., ark, K. S., 004. Corporat govrnanc and frm valu: vdnc from th Koran fnancal crss. Journal of nancal Economcs 7, Bhattacharya, U., 003. Optmal dsgn of ponz schms n fnt conoms. Journal of nancal Intrmdaton, -4. Blltt, M., lannry, M., Garfnkl, J., 995. Th ffct of lndr dntty on a borrowng frm's uty rturn. Journal of nanc 50,

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53 gur Intractons btwn th man playrs n th modl Extrnal Agncy otntal Balout Tax/Warrant Soluton Socal lannr Taxs otntal Balout ndr of ast Rsort Taxs ocal rm oans ocal Bank Intrst cy oans Intrst Extrnal ndr 5