#07-24
Banks, Markets and Liquidity
Franklin Allen and Elena Carletti, August 2007
Abstract: The banking sector is one of the most highly regulated sectors in the economy. However,
in contrast to other regulated sectors there is no wide agreement on the market failures
that justify regulation. We suggest that there are two important ones. The first is a
coordination problem that arises because of multiple equilibria. If people believe there is
going to be a panic then that can be self-fulfilling. If they believe there will be no panic
then that can also be self-fulfilling. Policy analysis is difficult in this case because our
knowledge of equilibrium selection mechanisms is limited. Global games represent one
promising modeling technique but as yet there is limited empirical evidence in support of
this approach. The second market failure is that if there are incomplete markets the
provision of liquidity is inefficient. In particular there must be significant price volatility
in order for the providers of liquidity to earn the opportunity cost of holding liquidity.
We argue that financial fragility, contagion, and asset price bubbles are manifestations of
inefficient liquidity provision.
Keywords:
JEL classifications:
