Working Paper: NBER ID: w12959
Authors: Emmanuel Farhi; Mikhail Golosov; Aleh Tsyvinski
Abstract: This paper studies a mechanism design model of financial intermediation. There are two informational frictions: agents receive unobservable shocks and can participate in markets by engaging in trades unobservable to intermediaries. Without regulations, intermediaries provide no risk sharing because of an externality arising from arbitrage opportunities. We identify a simple regulation -- a liquidity requirement -- that corrects such an externality by affecting the interest rate on the markets. We characterize the form of the optimal liquidity adequacy requirement for a general class of preferences. We show that whether markets underprovide or overprovide liquidity, and whether a liquidity cap or a liquidity floor should be used depends on the nature of the shocks that agents experience. Moreover, we prove that the optimal liquidity adequacy requirement implements a constrained efficient allocation subject to unobservable types and trades. We provide closed form solutions for the optimal liquidity requirement and welfare gains of imposing such requirements for two important special cases. In contrast with the existing literature, the necessity of regulation does not depend on exogenous incompleteness of markets for aggregate shocks.
Keywords: optimal regulations; financial intermediation; optimal contracts; market failures; mechanism design
JEL Codes: E6; G18; G2; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Informational frictions (D89) | Market failure in the provision of liquidity (E44) |
| Lack of regulation (G18) | No risk sharing by intermediaries (G21) |
| Liquidity requirement (E41) | Corrects externality (D62) |
| Liquidity requirement (E41) | Affects interest rates in the market (E43) |
| Liquidity requirement (E41) | Improves welfare (D69) |
| Optimal liquidity requirement (E41) | Implements constrained efficient allocation (D61) |
| Liquidity regulation (G28) | Achieves welfare gains (D69) |
| Liquidity requirement form (G33) | Depends on nature of shocks (C69) |