Crony Capitalism and Financial System Stability

Abstract

With the Asian financial crises, people identified crony relationships as the ultimate cause of bank instability. We examine the issue of crony capitalism in the context of model economy in which cronies are a class of project owners that have access to a government loan guarantee. While such a loan guarantee may induce more risk taking on the part of the crony--moral hazard--bank instability does not necessarily follow from the moral hazard problem. Rather, it is collapse of the government loan guarantee program that plays an important role in destablizing banks. Banks have insufficient equity stockpiled against the unexpected abandonment of the government loan guarantee.