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A Theory of Liquidity and Regulation of Financial Intermediation

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  • Emmanuel Farhi
  • Mikhail Golosov
  • Aleh Tsyvinski

Abstract

This paper studies a mechanism design model of financial intermediation. There are two informational frictions: agents receive unobservable shocks and can participate in markets by engaging in trades unobservable to intermediaries. Without regulations, intermediaries provide no risk sharing because of an externality arising from arbitrage opportunities. We identify a simple regulation -- a liquidity requirement -- that corrects such an externality by affecting the interest rate on the markets. We characterize the form of the optimal liquidity adequacy requirement for a general class of preferences. We show that whether markets underprovide or overprovide liquidity, and whether a liquidity cap or a liquidity floor should be used depends on the nature of the shocks that agents experience. Moreover, we prove that the optimal liquidity adequacy requirement implements a constrained efficient allocation subject to unobservable types and trades. We provide closed form solutions for the optimal liquidity requirement and welfare gains of imposing such requirements for two important special cases. In contrast with the existing literature, the necessity of regulation does not depend on exogenous incompleteness of markets for aggregate shocks.

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Paper provided by David K. Levine in its series Levine's Working Paper Archive with number 122247000000002006.

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Date of creation: 21 Mar 2008
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Handle: RePEc:cla:levarc:122247000000002006

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  2. Gorton, Gary & Winton, Andrew, 2003. "Financial intermediation," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 8, pages 431-552 Elsevier.
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  17. von Thadden, Ernst-Ludwig, 1999. "Liquidity creation through banks and markets: Multiple insurance and limited market access," European Economic Review, Elsevier, vol. 43(4-6), pages 991-1006, April.
  18. Mikhail Golosov & Aleh Tsyvinski & Ivan Werning, 2007. "New Dynamic Public Finance: A User's Guide," NBER Chapters, in: NBER Macroeconomics Annual 2006, Volume 21, pages 317-388 National Bureau of Economic Research, Inc.
  19. Xavier Freixas & Jean-Charles Rochet, 1997. "Microeconomics of Banking," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262061937, January.
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