Banks, Markets and Liquidity

Wharton Financial Institutions Center Working Paper No. 07-24

32 Pages Posted: 17 Oct 2007

See all articles by Franklin Allen

Franklin Allen

Imperial College London

Elena Carletti

Bocconi University - Department of Finance; European University Institute - Robert Schuman Centre for Advanced Studies (RSCAS)

Date Written: 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 failuresthat 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.

Suggested Citation

Allen, Franklin and Carletti, Elena, Banks, Markets and Liquidity (August 2007). Wharton Financial Institutions Center Working Paper No. 07-24. Available at SSRN: https://ssrn.com/abstract=1021734 or http://dx.doi.org/10.2139/ssrn.1021734

Franklin Allen (Contact Author)

Imperial College London ( email )

South Kensington Campus
Exhibition Road
London, Greater London SW7 2AZ
United Kingdom

Elena Carletti

Bocconi University - Department of Finance ( email )

Via Roentgen 1
Milano, MI 20136
Italy

European University Institute - Robert Schuman Centre for Advanced Studies (RSCAS) ( email )

Villa La Fonte, via delle Fontanelle 18
50016 San Domenico di Fiesole
Florence, Florence 50014
Italy

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