Financial fragility and over-the-counter markets

I propose a model to study whether trade frictions in an over-the-counter market for financial assets exacerbate or attenuate financial fragility. I model the financial sector as a large number of financial institutions, which I label banks. Each bank is a coalition of depositors and depositors are subject to privately observed liquidity shocks. The banks' problem is to maximize the welfare of depositors by implementing the efficient allocation of financial assets among them. I show that when banks use the balanced team mechanism, proposed by Athey and Segal (2013), there is always a truth-telling equilibrium which supports the constrained Pareto efficient allocation. When the frictions in the over-the-counter market are small, this equilibrium is unique. However, I provide numerical examples in which these frictions are severe and the economy has other equilibria. In one equilibrium depositors claim high liquidity needs, asset price falls, the trade volume collapses and, consequently, the equilibrium allocation is not constrained Pareto efficient. I label this equilibrium a bank-run equilibrium and I interpret the existence of bank-runs as a financial fragility. I propose two policies to eliminate bank-run equilibria. The first is a suspension scheme and the second is an opening of trade facilities similar to the ones established by the Federal Reserve Bank during the 2007-08 financial crisis. Both policies can eliminate bank runs when contingent on announcements of liquidity needs in a large number of banks.