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.