IDEAS home Printed from https://ideas.repec.org/p/red/sed017/1122.html
   My bibliography  Save this paper

Financial Fragility and Over-the-counter Markets

Author

Listed:
  • Bruno Sultanum

    (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 search friction 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

  • Bruno Sultanum, 2017. "Financial Fragility and Over-the-counter Markets," 2017 Meeting Papers 1122, Society for Economic Dynamics.
  • Handle: RePEc:red:sed017:1122
    as

    Download full text from publisher

    File URL: https://economicdynamics.org/meetpapers/2017/paper_1122.pdf
    Download Restriction: no
    ---><---

    Other versions of this item:

    References listed on IDEAS

    as
    1. Lagos, Ricardo & Rocheteau, Guillaume & Weill, Pierre-Olivier, 2011. "Crises and liquidity in over-the-counter markets," Journal of Economic Theory, Elsevier, vol. 146(6), pages 2169-2205.
    2. John H. Cochrane, 2014. "Toward a Run-free Financial System," Book Chapters, in: Martin Neil Baily & John B. Taylor (ed.), Across the Great Divide: New Perspectives on the Financial Crisis, chapter 10, Hoover Institution, Stanford University.
    3. Alberto Trejos & Randall Wright, 2014. "Search-Based Models of Money and Finance: An Integrated Approach," Working Papers 709, Federal Reserve Bank of Minneapolis.
    4. Andolfatto, David & Nosal, Ed & Wallace, Neil, 2007. "The role of independence in the Green-Lin Diamond-Dybvig model," Journal of Economic Theory, Elsevier, vol. 137(1), pages 709-715, November.
    5. Ennis, Huberto M. & Keister, Todd, 2003. "Economic growth, liquidity, and bank runs," Journal of Economic Theory, Elsevier, vol. 109(2), pages 220-245, April.
    6. Green, Edward J. & Lin, Ping, 2003. "Implementing efficient allocations in a model of financial intermediation," Journal of Economic Theory, Elsevier, vol. 109(1), pages 1-23, March.
    7. Drew Fudenberg & Jean Tirole, 1991. "Game Theory," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262061414, September.
    8. Shi Shougong, 1995. "Money and Prices: A Model of Search and Bargaining," Journal of Economic Theory, Elsevier, vol. 67(2), pages 467-496, December.
    9. Daniel Covitz & Nellie Liang & Gustavo A. Suarez, 2013. "The Evolution of a Financial Crisis: Collapse of the Asset-Backed Commercial Paper Market," Journal of Finance, American Finance Association, vol. 68(3), pages 815-848, June.
    10. Marcin Kacperczyk & Philipp Schnabl, 2010. "When Safe Proved Risky: Commercial Paper during the Financial Crisis of 2007-2009," Journal of Economic Perspectives, American Economic Association, vol. 24(1), pages 29-50, Winter.
    11. Ricardo Lagos & Guillaume Rocheteau, 2009. "Liquidity in Asset Markets With Search Frictions," Econometrica, Econometric Society, vol. 77(2), pages 403-426, March.
    12. Sumit Agarwal & Jacqueline Barrett & Mariacristina De Nardi, 2011. "The asset-backed securities markets, the crisis, and TALF," Profitwise, Federal Reserve Bank of Chicago, issue Apr, pages 8-18.
    13. Franklin Allen & Douglas Gale, 2004. "Financial Intermediaries and Markets," Econometrica, Econometric Society, vol. 72(4), pages 1023-1061, July.
    14. Darrell Duffie, 2012. "Over-The-Counter Markets," Introductory Chapters, in: Dark Markets: Asset Pricing and Information Transmission in Over-the-Counter Markets, Princeton University Press.
    15. Demski, Joel S. & Sappington, David, 1984. "Optimal incentive contracts with multiple agents," Journal of Economic Theory, Elsevier, vol. 33(1), pages 152-171, June.
    16. R. de O. Cavalcanti & P. K. Monteiro, 2016. "Enriching information to prevent bank runs," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 62(3), pages 477-494, August.
    17. Franklin Allen & Douglas Gale, 2000. "Financial Contagion," Journal of Political Economy, University of Chicago Press, vol. 108(1), pages 1-33, February.
    18. Renou, Ludovic & Tomala, Tristan, 2015. "Approximate implementation in Markovian environments," Journal of Economic Theory, Elsevier, vol. 159(PA), pages 401-442.
    19. Trejos, Alberto & Wright, Randall, 1995. "Search, Bargaining, Money, and Prices," Journal of Political Economy, University of Chicago Press, vol. 103(1), pages 118-141, February.
    20. Huberto M. Ennis & Todd Keister, 2009. "Bank Runs and Institutions: The Perils of Intervention," American Economic Review, American Economic Association, vol. 99(4), pages 1588-1607, September.
    21. Ennis, Huberto M. & Keister, Todd, 2009. "Run equilibria in the Green-Lin model of financial intermediation," Journal of Economic Theory, Elsevier, vol. 144(5), pages 1996-2020, September.
    22. Marcin Kacperczyk & Philipp Schnabl, 2013. "How Safe Are Money Market Funds?," The Quarterly Journal of Economics, Oxford University Press, vol. 128(3), pages 1073-1122.
    23. Susan Athey & Ilya Segal, 2013. "An Efficient Dynamic Mechanism," Econometrica, Econometric Society, vol. 81(6), pages 2463-2485, November.
    24. Schmidt, Lawrence & Timmermann, Allan G & Wermers, Russ, 2014. "Runs on Money Market Funds," CEPR Discussion Papers 9906, C.E.P.R. Discussion Papers.
    25. Douglas W. Diamond & Philip H. Dybvig, 2000. "Bank runs, deposit insurance, and liquidity," Quarterly Review, Federal Reserve Bank of Minneapolis, vol. 24(Win), pages 14-23.
    26. Renee Courtois Haltom & Bruno Sultanum, 2018. "Preventing Bank Runs," Richmond Fed Economic Brief, Federal Reserve Bank of Richmond, issue March.
    27. Boyd, John H. & Prescott, Edward C., 1986. "Financial intermediary-coalitions," Journal of Economic Theory, Elsevier, vol. 38(2), pages 211-232, April.
    28. Nathan Foley-Fisher & Borghan Narajabad & Stéphane Verani, 2020. "Self-Fulfilling Runs: Evidence from the US Life Insurance Industry," Journal of Political Economy, University of Chicago Press, vol. 128(9), pages 3520-3569.
    29. James Peck & Karl Shell, 2003. "Bank Portfolio Restrictions and Equilibrium Bank Runs," Levine's Bibliography 666156000000000077, UCLA Department of Economics.
    30. Myerson, Roger B. & Satterthwaite, Mark A., 1983. "Efficient mechanisms for bilateral trading," Journal of Economic Theory, Elsevier, vol. 29(2), pages 265-281, April.
    31. James Peck & Karl Shell, 2003. "Equilibrium Bank Runs," Journal of Political Economy, University of Chicago Press, vol. 111(1), pages 103-123, February.
    32. Postlewaite, Andrew & Schmeidler, David, 1986. "Implementation in differential information economies," Journal of Economic Theory, Elsevier, vol. 39(1), pages 14-33, June.
    33. Bryant, John, 1980. "A model of reserves, bank runs, and deposit insurance," Journal of Banking & Finance, Elsevier, vol. 4(4), pages 335-344, December.
    34. Lawrence Schmidt & Allan Timmermann & Russ Wermers, 2016. "Runs on Money Market Mutual Funds," American Economic Review, American Economic Association, vol. 106(9), pages 2625-2657, September.
    35. Semyon Malamud & Marzena Rostek, 2017. "Decentralized Exchange," American Economic Review, American Economic Association, vol. 107(11), pages 3320-3362, November.
    36. Gorton, Gary & Metrick, Andrew, 2012. "Securitized banking and the run on repo," Journal of Financial Economics, Elsevier, vol. 104(3), pages 425-451.
    37. Neil Wallace, 1988. "Another attempt to explain an illiquid banking system: the Diamond and Dybvig model with sequential service taken seriously," Quarterly Review, Federal Reserve Bank of Minneapolis, vol. 12(Fall), pages 3-16.
    38. d'Aspremont, Claude & Gerard-Varet, Louis-Andre, 1979. "Incentives and incomplete information," Journal of Public Economics, Elsevier, vol. 11(1), pages 25-45, February.
    39. Zachary Bethune & Bruno Sultanum & Nicholas Trachter, 2016. "Private Information in Over-the-Counter Markets," Working Paper 16-16, Federal Reserve Bank of Richmond.
    40. Cooper, Russell & Ross, Thomas W., 1998. "Bank runs: Liquidity costs and investment distortions," Journal of Monetary Economics, Elsevier, vol. 41(1), pages 27-38, February.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. 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.
    2. Donaldson, Jason Roderick & Piacentino, Giorgia, 2019. "Money Runs," CEPR Discussion Papers 13955, C.E.P.R. Discussion Papers.
    3. Jason R. Donaldson & Giorgia Piacentino, 2019. "Money Runs," NBER Working Papers 26298, National Bureau of Economic Research, Inc.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. Kučinskas, Simas, 2019. "Aggregate risk and efficiency of mutual funds," Journal of Banking & Finance, Elsevier, vol. 101(C), pages 1-11.
    2. David Andolfatto & Ed Nosal & Bruno Sultanum, 2014. "Preventing bank runs," Working Papers 2014-21, Federal Reserve Bank of St. Louis.
    3. Huberto Ennis & Todd Keister, 2016. "Optimal banking contracts and financial fragility," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 61(2), pages 335-363, February.
    4. Renee Courtois Haltom & Bruno Sultanum, 2018. "Preventing Bank Runs," Richmond Fed Economic Brief, Federal Reserve Bank of Richmond, issue March.
    5. Kinateder, Markus & Kiss, Hubert János, 2014. "Sequential decisions in the Diamond–Dybvig banking model," Journal of Financial Stability, Elsevier, vol. 15(C), pages 149-160.
    6. Lazopoulos, Ioannis, 2013. "Liquidity uncertainty and intermediation," Journal of Banking & Finance, Elsevier, vol. 37(2), pages 403-414.
    7. Simas Kucinskas, 2015. "Liquidity Creation without Banks," Tinbergen Institute Discussion Papers 15-101/VI, Tinbergen Institute.
    8. Bertolai, Jefferson Donizeti Pereira & de Melo, Matheus Anthony, 2017. "Fragilidade bancária com (e sem) serviço sequencial," Revista Brasileira de Economia - RBE, EPGE Brazilian School of Economics and Finance - FGV EPGE (Brazil), vol. 71(3), September.
    9. Li, Yang, 2017. "Interest rates and financial fragility," Journal of Economic Dynamics and Control, Elsevier, vol. 82(C), pages 195-205.
    10. Todd Keister, 2016. "Bailouts and Financial Fragility," Review of Economic Studies, Oxford University Press, vol. 83(2), pages 704-736.
    11. R. de O. Cavalcanti & P. K. Monteiro, 2016. "Enriching information to prevent bank runs," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 62(3), pages 477-494, August.
    12. Simas Kucinskas, 2015. "Liquidity creation without banks," DNB Working Papers 482, Netherlands Central Bank, Research Department.
    13. Ennis, Huberto M. & Keister, Todd, 2010. "Banking panics and policy responses," Journal of Monetary Economics, Elsevier, vol. 57(4), pages 404-419, May.
    14. Todd Keister & Vijay Narasiman, 2016. "Expectations vs. Fundamentals- driven Bank Runs: When Should Bailouts be Permitted?," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 21, pages 89-104, July.
    15. Donaldson, Jason Roderick & Piacentino, Giorgia, 2019. "Money Runs," CEPR Discussion Papers 13955, C.E.P.R. Discussion Papers.
    16. Ryuichiro Izumi, 2021. "Opacity: Insurance and Fragility," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 40, pages 146-169, April.
    17. Daniel R. Sanches, 2014. "Banking panics and protracted recessions," Working Papers 14-37, Federal Reserve Bank of Philadelphia.
    18. Hubert J. Kiss & Ismael Rodriguez-Lara & Alfonso Rosa-Garcia, 2020. "Who withdraws first? Line formation during bank runs," ThE Papers 20/02, Department of Economic Theory and Economic History of the University of Granada..
    19. Markus Kinateder & Hubert Janos Kiss & Agnes Pinter, 2015. "Would depositors like to show others that they do not withdraw? Theory and Experiment," CERS-IE WORKING PAPERS 1553, Institute of Economics, Centre for Economic and Regional Studies.
    20. Huberto M. Ennis & Todd Keister, 2008. "Run equilibria in a model of financial intermediation," Staff Reports 312, Federal Reserve Bank of New York.

    More about this item

    JEL classification:

    • E - Macroeconomics and Monetary Economics
    • G - Financial Economics

    NEP fields

    This paper has been announced in the following NEP Reports:

    Statistics

    Access and download statistics

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:red:sed017:1122. See general information about how to correct material in RePEc.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Christian Zimmermann). General contact details of provider: https://edirc.repec.org/data/sedddea.html .

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service hosted by the Research Division of the Federal Reserve Bank of St. Louis . RePEc uses bibliographic data supplied by the respective publishers.