Financial institutions and the financial crisis in East Asia

This paper investigates institutional reasons for the soft-budget constrain t problem; and how the soft-budget constraint problem creates conditions wh ich may result in a financial crisis. As a consequence of soft-budget const raints, bad projects do not stop; bad loans accumulate; and banks and depos itors do not receive bad news on time. Poorly informed depositors are then likely to herd to overinvest when there is no bankruptcy ('frenzy'), and th ey are likely to herd to panic when bankruptcy occurs ('crash'), which may be the result of excessive bad loans that are also a consequence of soft-bu dget constraints. In contrast, under hard-budget constraints information is disclosed quickly regarding liquidation. Better-informed investors are the n less likely to herd wrongly. (C) 1999 Elsevier Science B.V. Ail rights re served. JEL classification: E44; G21; P51; F36.