Financial Intermediaries and Markets

A complex financial system comprises both financial markets and financial intermediaries. We distinguish financial intermediaries according to whether they issue complete contingent contracts or incomplete contracts. Intermediaries such as banks that issue incomplete contracts, e.g., demand deposits, are subject to runs, but this does not imply a market failure. A sophisticated financial system–a system with complete markets for aggregate risk and limited market participation–is incentive-efficient, if the intermediaries issue complete contingent contracts, or else constrained-efficient, if they issue incomplete contracts. We argue that there may be a role for regulating liquidity provision in an economy in which markets for aggregate risks are incomplete. 1 Markets, intermediaries and crises For a long time, it has been taken as axiomatic that financial crises are best avoided. We confront this conventional wisdom by showing that, under certain conditions, a laisser-faire financial system achieves the incentive-efficient or constrained-efficient allocation.1 Furthermore, constrained efficiency may require financial crises in equilibrium. The assumptions needed to achieve these efficiency results are restrictive, but no more so than the assumptions normally required to ensure Pareto-efficiency of Walrasian equilibrium. The important point is that optimality of avoiding crises should not be taken as axiomatic. If regulation is required to minimize or obviate the costs of financial crises, it should be justified by a microeconomic welfare analysis based on standard assumptions. Furthermore, the form of the intervention should be derived from microeconomic principles. Financial institutions and financial markets exist to facilitate the efficient allocation of risks and resources. Any government intervention will have an impact on the normal functioning of the financial system. A policy of preventing financial crises will inevitably create distortions. One of the advantages of a microeconomic analysis of financial crises is that it clarifies the costs and benefits of these distortions. Policy analyses of banking and securities markets tend to be based on very specific models.2 In the absence of a general equilibrium framework, it is hard to evaluate the robustness of the results and, ultimately, to answer the question: What precisely are the market failures associated with financial crises? In this paper, we take a step toward developing a general model to analyze market failures in the financial sector and study a complex, decentralized, financial system comprising both financial markets and financial intermediaries.3 For the most part, the seminal models of bank runs, such as Bryant (1980) and Diamond and Dybvig (1983), analyze the behavior of a single bank and consist of a contracting problem followed by a coordination problem.4 We combine recent developments in the theory of bank1Wallace (1990) suggests that bank runs might be efficient. Examples of efficient bank runs were provided by Alonso (1996) and Allen and Gale (1998). Here we provide general sufficient conditions for the efficiency of financial crises. 2See Bhattacharya and Thakor (1993) for a survey. For examples of more recent work that stresses the analysis of welfare, see Matutes and Vives (1996, 2000). 3In this paper we use the term “financial markets” narrowly to denote markets for securities. Other authors have allowed for markets in which mechanisms are traded (e.g., Bisin and Gottardi (2000)). We prefer to call this intermediation. Formally, the two activities are similar, but in practice the economic institutions are quite different. 4Early models of financial crises were developed in the 1980s by Bryant (1980) and Diamond and Dybvig (1983). Important contributions were also made by Chari and Jagannathan (1988), Chari (1989), Champ, Smith, and Williamson (1996), Jacklin (1986), Jacklin and Bhattacharya (1988), Postlewaite and Vives (1986), Wallace (1988; 1990) and others. Theoretical research on speculative currency attacks, banking panics, the role of liquidity and contagion have taken a number of approaches. One is built on the foundations provided by early research on bank runs (e.g., Hellwig (1994; 1998), Diamond (1997), Allen and Gale (1998; 1999; 2000a; 2000b), Peck and Shell (1999), Chang and Velasco (2000; 2001)) and Diamond and Rajan (2001)). Other approaches include those based on macroeconomic models of currency crises that developed from the insights of Krugman (1979), Obstfeld (1986) and Calvo (1988) (see, e.g., Corsetti, Pesenti, and Roubini (1999) for a recent contribution and Flood and Marion (1999) for a survey), game theoretic models