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Financial Fragility and Over-the-Counter Markets

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  • Sultanum, Bruno

    (Federal Reserve Bank of Richmond)

Abstract

This paper studies the interaction between financial fragility and over-the-counter markets. In the model, the financial sector is composed of a large number of investors divided into different groups, which are interpreted as financial institutions, and a large number of dealers. Financial institutions and dealers trade assets in an over-the-counter market à la Duffie et al. (2005) and Lagos and Rocheteau (2009). Investors are subject to 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 its investors. I show that when the market is more liquid, in the sense that the searchfriction is mild, the economy is more likely to have a unique equilibrium and, therefore, is not fragile. However, when the search friction is severe, I provide examples with run equilibria—where investors announce low valuation of assets because they believe everyone else in their financial institution is doing the same. In terms of welfare, I find that, conditional on bank runs existing, the welfare impact of the search friction is ambiguous. The reason is that, 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, 2016. "Financial Fragility and Over-the-Counter Markets," Working Paper 16-4, Federal Reserve Bank of Richmond.
  • Handle: RePEc:fip:fedrwp:16-04
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    References listed on IDEAS

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    More about this item

    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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