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Financial Fragility and Over-the-counter Markets

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  • 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
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    Cited by:

    1. Pinter, Gabor & Uslu, Semih, 2022. "Comparing search and intermediation frictions across markets," Bank of England working papers 974, Bank of England.
    2. 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.
    3. Donaldson, Jason & Piacentino, Giorgia, 2019. "Money Runs," CEPR Discussion Papers 13955, C.E.P.R. Discussion Papers.
    4. Donaldson, Jason Roderick & Piacentino, Giorgia, 2022. "Money runs," Journal of Monetary Economics, Elsevier, vol. 126(C), pages 35-57.
    5. Jason R. Donaldson & Giorgia Piacentino, 2019. "Money Runs," NBER Working Papers 26298, National Bureau of Economic Research, Inc.

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    • G - Financial Economics

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