policymakers demonstrate

482 Thorsten Beck, Elena Carletti and Itay Goldstein
stronger interplay between financial institutions and financial markets in modern
financial systems, as we shall stress later in the chapter. In summary, problems
of runs and panics, and ways of reducing their likelihood are important,
as is the challenge of the regulatory perimeter, as funding and thus sources of
contagion can easily move outside the traditional banking system. The changing
nature of bank runs also reflects the dynamic and rapidly changing nature
of financial systems.
Moral Hazard and Incentives
The put-option character of banking provides incentives to bank owners to take
aggressive risk (see, for example, the discussion in Carletti, 2008). Specifically,
bank owners participate only in the upside of their risk decisions, while their
losses are limited to their paid-in capital. This moral hazard problem is exacerbated
by guarantees provided by governments targeted at avoiding the coordination
problems and panics discussed above, which in turn might encourage
bad behavior and excessive risk-taking. Knowing that the government is concerned
about panics (described above) and/or contagion (described below), and
will take steps to make sure that banks do not fail, banks might internalize less
the consequences of their risk-taking, and so bring the system to a more fragile
state. Hence, governments typically have to supplement any guarantees policy
with restrictions on bank policies to curtail any incentive for excessive risktaking.
Such restrictions include, for example, imposing capital requirements
on banks, reducing their risk taking incentives. Another important restriction
to excessive risk-taking would be to allow banks to fail, thus forcing risk takers
to face losses.
But moral hazard, incentive problems, and excessive risk-taking are not only
the result of government guarantees. Allen and Gale (2000a) study the interaction
between incentives in the financial system and asset prices. The idea is that
many investors in real estate and stock markets obtain their investment funds
from external sources but the ultimate fund providers are unable to observe
the characteristics of the investment. This leads to a classic asset-substitution
problem, which increases the return to investment in risky assets and causes
investors to bid up prices above their fundamental values. A crucial determinant
of asset prices is thus the amount of credit provided by the financial system. By
expanding the volume of credit and creating uncertainty about the future path
of credit expansion, financial liberalization can interact with the agency problem
and lead to a bubble in asset prices. When the bubble bursts, either because
returns are low or because the central bank tightens credit, there is a financial
crisis.
This is indeed consistent with the vast evidence that a banking crisis often follows
collapse in asset prices after what appears to have been a ‘bubble’. This is
in contrast to standard neoclassical theory and the efficient markets hypothesis,