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 National Bureau of Economic Research, Inc in its series NBER Working Papers with number
12959.
Length: Date of creation: Mar 2007 Date of revision: Handle: RePEc:nbr:nberwo:12959
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Find related papers by JEL classification: E6 - Macroeconomics and Monetary Economics - - Macroeconomic Policy, Macroeconomic Aspects of Public Finance, and General Outlook G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation G2 - Financial Economics - - Financial Institutions and Services G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
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Ricardo Caballero & Arvind Krishnamurthy, 2001.
"Smoothing Sudden Stops,"
NBER Working Papers
8427, National Bureau of Economic Research, Inc.
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