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Financial fragility and over-the-counter markets

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  • Sultanum, Bruno

Abstract

This paper studies the interaction between financial fragility and over-the-counter (OTC) markets. I model the financial sector as a large number of investors divided into different groups, which I interpret as financial institutions, and a large number of dealers. Financial institutions and dealers trade assets in an OTC market à laDuffie et al. (2005) and Lagos and Rocheteau (2009). Investors receive privately observed preference shocks, and financial institutions use the balanced team mechanism, proposed by Athey and Segal (2013), to implement an efficient risk-sharing arrangement among their investors. When the market is liquid, in the sense that search and bargaining are small frictions, I show that the economy is likely to have a unique equilibrium and, therefore, is not fragile. When these frictions are severe, a run equilibrium exists—investors announce low valuation of assets because they believe everyone else in their financial institution is doing the same. Conditional on bank runs existing, the welfare impact of the search friction is ambiguous. During runs, trade is inefficient, and, as a result, a friction that reduces trade during runs has the potential to improve welfare. This result is in sharp contrast with the existing literature, which suggests that search friction has a negative impact on welfare.

Suggested Citation

  • Sultanum, Bruno, 2018. "Financial fragility and over-the-counter markets," Journal of Economic Theory, Elsevier, vol. 177(C), pages 616-658.
  • Handle: RePEc:eee:jetheo:v:177:y:2018:i:c:p:616-658
    DOI: 10.1016/j.jet.2018.07.002
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    Cited by:

    1. Donaldson, Jason & Piacentino, Giorgia, 2019. "Money Runs," CEPR Discussion Papers 13955, C.E.P.R. Discussion Papers.
    2. Pinter, Gabor & Uslu, Semih, 2022. "Comparing search and intermediation frictions across markets," Bank of England working papers 974, Bank of England.
    3. Igor Kravchuk, 2019. "Management of Investment Funds Financial Fragility," Montenegrin Journal of Economics, Economic Laboratory for Transition Research (ELIT), vol. 15(4), pages 17-32.
    4. Donaldson, Jason Roderick & Piacentino, Giorgia, 2022. "Money runs," Journal of Monetary Economics, Elsevier, vol. 126(C), pages 35-57.
    5. Jason R. Donaldson & Giorgia Piacentino, 2019. "Money Runs," NBER Working Papers 26298, National Bureau of Economic Research, Inc.

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    More about this item

    Keywords

    Decentralized trade; Search; Liquidity; Financial fragility; Bank-run; Dynamic mechanism design;
    All these keywords.

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • G01 - Financial Economics - - General - - - Financial Crises
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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