TAILIEUCHUNG - OPTIMAL FINANCIAL CRISES BY FRANKLIN ALLEN AND DOUGLAS GALE

According to the definition of herd behavior given above, herding results from an obvious intent by investors to copy the behavior of other investors. This should be distinguished from “spurious herding” where groups facing similar decision problems and information sets take similar decisions. Such spurious herding is an efficient outcome whereas “intentional” herding, as explained in Section I, need not be efficient. But it needs pointing out that empirically distinguishing “spurious herding” from “intentional” herding is easier said than done and may even be impossible, since typically, a multitude of factors have the potential to affect an investment decision | THE JOURNAL OF FINANCE VOL. LIII NO. 4 AUGUST 1998 Optimal Financial Crises FRANKLIN ALLEN and DOUGLAS GALE ABSTRACT Empirical evidence suggests that banking panics are related to the business cycle and are not simply the result of sunspots. Panics occur when depositors perceive that the returns on bank assets are going to be unusually low. We develop a simple model of this. In this setting bank runs can be first-best efficient they allow efficient risk sharing between early and late withdrawing depositors and they allow banks to hold efficient portfolios. However if costly runs or markets for risky assets are introduced central bank intervention of the right kind can lead to a Pareto improvement in welfare. From the earliest times banks have been plagued by the problem of bank runs in which many or all of the bank s depositors attempt to withdraw their funds simultaneously. Because banks issue liquid liabilities in the form of deposit contracts but invest in illiquid assets in the form of loans they are vulnerable to runs that can lead to closure and liquidation. A financial crisis or banking panic occurs when depositors at many or all of the banks in a region or a country attempt to withdraw their funds simultaneously. Prior to the twentieth century banking panics occurred f requently in Europe and the United States. Panics were generally regarded as a bad thing and the development of central banks to eliminate panics and ensure f inan-cial stability has been an important feature of the history of financial systems. It has been a long and involved process. The f irst central bank the Bank of Sweden was established more than 300 years ago. The Bank of England played an especially important role in the development of effective stabilization policies in the eighteenth and nineteenth centuries. By the end of the nineteenth century banking panics had been eliminated in Europe. The last true panic in England was the Overend Gurney Company Crisis of 1866. Allen is from

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