With respect to banking crises, economists have constructed models capable of explaining such events despite their undesirable consequences but those models cannot explain why the influences they identify express themselves in some countries much more than in others. Theories of banking crises posit three aspects of banking, some combination of which are presumed to explain the origins of crises: bank structure, interbank connections, and human nature. Bank structure refers to the maturity and liquidity mismatch between banks relatively illiquid and long-lived loans and their relatively liquid and short-lived liabilities. Structural theories regard banki ng crises as the result of the inherent exposure of banks to liquidity risk arising from this mismatch. Interbank connections can exacerbate crisis risk through the problem of risk externalities. Individual banks will choose their holdings of liquid assets and their leverage (debt relative to equity capital) based on their individual interests, and will not take into account the social costs that arise from the spill over effects (externalities) created by interbank connections. According to this class of crisis theories, the primary role of regulation is to internalize externalities by forcing banks to hold more cash assets and to maintain lower leverage ratios than they would choose voluntarily. The absence of sufficient regulation to internalize externalities, therefore, is the cause of banking crises. Other theories see banking crises as symptoms of human natures myopia, which drives destructive cycles of greed and fear.”
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