Financial Inst it ut ions, Financial Cont agion, and Financial Crises ¤ Haizhou Huang y and Chenggang Xu z First draft : August 1998; T his draft : Sept ember 1999 A b st r act T his paper endogenizes …nancial cont agion and …nancial crises from …nancial inst it ut ions. Financial crises can emanat e from …nancial inst it ut ions which gen- erate soft-budget constraints (SBC). The prevailing SBC in an economy distorts information such that the interbank lending market faces a “ lemon” problem. The lemon problem in the lending market may contribute to bank run conta- gions and can lead to the collapse of the lending market and induce a run on the economy. Moreover, due to the lemon problem in the …nancial system, a ratio- nal government policy in this economy may lead to a SBC trap such that all the illiquid banks must be bailed out which may further enhence SBC syndrom. In comparison, an economy wit h a predominance of diversi…ed …nancial inst it ut ions is characterized by hard-budget constraints (HBC). In this HBC economy … rms disclose timely information to the banks and to the …nancial market as a whole. T hus bank runs isolat ed and …nancial crisis are prevent ed. ¤ We are indebted to Charles Goodhart and Eric Maskin for their comments. We are also grateful to William Alexander, Abhijit Banerjee, Tito Cordella, Mathias Dewatripont, Nich Hope, Xavier Freixas, Nobu Kiyotaki, Janos Kornai, John Moore, Dwight Perkins, Katharina Pistor, Yingyi Qian, Jean-Charles Rochet, and Jean Tirole for helpful conversations; to the seminar and conference par- ticipants at AEA, EEA, HIID, IMF, LSE, Southampton, Stanford, and Toulouse; and to Natalie Baumer and Nancy Hearst for edit orial assist ance. y International Monetary Fund. Email: hhuang@ imf.org. z Department of Economics, London School of Economics. Email: c.xu@ lse.ac.uk. 1