The Causes of Financial Instability

Abstract

In recent years we have witnessed a marked increase in episodes of crisis in the U.S. economy, e.g., the problems associated with Continental Illinois National Bank in 1984 and the stock market crash in 1987. In addition, failures of commercial banks and thrift institutions have reached levels not seen since the Depression. The term financial instability will be used in this paper to refer to both the episodes of crisis and the troubles of the depository intermediaries (a more specific definition will be provided below). Our focus is on those developments that threaten widespread disruption to the normal functioning of the economic and systems. In this sense, the episodes of crisis are clearly examples of instability. In addition, though, the term as used here includes the increasing failures of the depository intermediaries. Unlike the problems of consumers or even nonfinancial businesses, widespread failures of depository intermediaries are more likely to threaten directly the entire system. These increasingly interconnected institutions have the unique role of extending credit and supplying liquidity on demand (see Dymski, 1988), and are central to the payments mechanism. Thus problems in the banking system can disrupt the overall economic and

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