A Theory of Liquidity and Regulation of Financial Intermediation

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Publication Details

Output type: Journal article

Author list: Farhi E, Golosov M, Tsyvinski A

Publisher: Oxford University Press

Publication year: 2009

Journal: The Review of Economic Studies (0034-6527)

Volume number: 76

Issue number: 3

Start page: 973

End page: 992

Number of pages: 20

ISSN: 0034-6527

eISSN: 1467-937X

Languages: English-Great Britain (EN-GB)

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Open access status: green

Full text URL: http://papers.nber.org/papers/w12959.pdf

Abstract

This paper studies a Diamond-Dybvig model of providing insurance against unobservable liquidity shocks in the presence of unobservable trades. We show that competitive equilibria are inefficient. A social planner finds it beneficial to introduce a wedge between the interest rate implicit in optimal allocations and the economy's marginal rate of transformation. This improves risk sharing by reducing the attractiveness of joint deviations where agents simultaneously misrepresent their type and engage in trades on private markets. We propose a simple implementation of the optimum that imposes a constraint on the portfolio share that financial intermediaries invest in short-term assets.

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