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A Theory of Liquidity and Regulation of Financial Intermediation

  • Emmanuel Farhi
  • Mikhail Golosov
  • Aleh Tsyvinski

This paper studies a Diamond-Dybvig model of providing insurance against unobservable liquidity shocks in the presence of unobservable trades. We show that competitive equilibria are inefficient. A social planner finds it beneficial to introduce a wedge between the interest rate implicit in optimal allocations and the economy's marginal rate of transformation. This improves risk sharing by reducing the attractiveness of joint deviations where agents simultaneously misrepresent their type and engage in trades on private markets. We propose a simple implementation of the optimum that imposes a constraint on the portfolio share that financial intermediaries invest in short-term assets. Copyright , Wiley-Blackwell.

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File URL: http://hdl.handle.net/10.1111/j.1467-937X.2009.00540.x
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Article provided by Oxford University Press in its journal The Review of Economic Studies.

Volume (Year): 76 (2009)
Issue (Month): 3 ()
Pages: 973-992

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Handle: RePEc:oup:restud:v:76:y:2009:i:3:p:973-992
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  1. Alberto Bisin & Adriano Rampini, 2006. "Exclusive contracts and the institution of bankruptcy," Economic Theory, Springer, vol. 27(2), pages 277-304, January.
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  6. Andrew Atkeson & Robert E Lucas, 2010. "On Efficient Distribution with Private Information," Levine's Working Paper Archive 2179, David K. Levine.
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  8. Gary Gorton & Andrew Winton, 2002. "Financial Intermediation," NBER Working Papers 8928, National Bureau of Economic Research, Inc.
  9. Merton, Robert C., 1977. "An analytic derivation of the cost of deposit insurance and loan guarantees An application of modern option pricing theory," Journal of Banking & Finance, Elsevier, vol. 1(1), pages 3-11, June.
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  11. Franklin Allen & Douglas Gale, 2003. "Financial Intermediaries and Markets," Center for Financial Institutions Working Papers 00-44, Wharton School Center for Financial Institutions, University of Pennsylvania.
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  18. Caballero, Ricardo J. & Krishnamurthy, Arvind, 2004. "Smoothing sudden stops," Journal of Economic Theory, Elsevier, vol. 119(1), pages 104-127, November.
  19. 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.
  20. Greenwald, Bruce C & Stiglitz, Joseph E, 1986. "Externalities in Economies with Imperfect Information and Incomplete Markets," The Quarterly Journal of Economics, MIT Press, vol. 101(2), pages 229-64, May.
  21. Arnott, Richard & Stiglitz, Joseph E., 1986. "Moral hazard and optimal commodity taxation," Journal of Public Economics, Elsevier, vol. 29(1), pages 1-24, February.
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