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Financial system: shock absorber or amplifier?


  • Franklin Allen
  • Elena Carletti


This paper identifies two types of market failures. The first concerns a coordination problem associated with panics. The problem in analysing this type of market failure from a policy perspective is that there is no widely accepted method for selecting equilibria. The second market failure concerns the incompleteness of financial markets. The essential problem here is that the incentives to provide liquidity lead to an inefficient allocation of resources. The paper outlines three manifestations of market failure associated with liquidity provision: financial fragility, contagion and asset price bubbles. The framework developed allows some insight into the question of when the financial system acts a shock absorber and when it acts as an amplifier. Having identified when there is a market failure, the paper looks at whether there are policies that can correct the undesirable effects of such failures.

Suggested Citation

  • Franklin Allen & Elena Carletti, 2008. "Financial system: shock absorber or amplifier?," BIS Working Papers 257, Bank for International Settlements.
  • Handle: RePEc:bis:biswps:257

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    References listed on IDEAS

    1. Franklin Allen & Douglas Gale, 2004. "Financial Intermediaries and Markets," Econometrica, Econometric Society, vol. 72(4), pages 1023-1061, July.
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    Cited by:

    1. Andreas Horsch, 2012. "Managerial Action And Financial Crisis," Polish Journal of Management Studies, Czestochowa Technical University, Department of Management, vol. 5(1), pages 7-33, June.
    2. Ang, James B., 2011. "Finance and consumption volatility: Evidence from India," Journal of International Money and Finance, Elsevier, vol. 30(6), pages 947-964, October.

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    bank regulation; financial crisis; financial intermediation; market failure;

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