Financial System: Shock Absorber or Amplifier?

26 Pages Posted: 22 Jul 2008

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: July 2008

Abstract

This paper identifies two types of market failures. The first concerns a coordination problem associated with panics. The problem in analysing this type of market failure from a policy perspective is that there is no widely accepted method for selecting equilibria. The second market failure concerns the incompleteness of financial markets. The essential problem here is that the incentives to provide liquidity lead to an inefficient allocation of resources. The paper outlines three manifestations of market failure associated with liquidity provision: financial fragility, contagion and asset price bubbles. The framework developed allows some insight into the question of when the financial system acts a shock absorber and when it acts as an amplifier. Having identified when there is a market failure, the paper looks at whether there are policies that can correct the undesirable effects of such failures.

(This paper includes comments by Yung Chul Park.)

Keywords: Bank regulation, financial crisis, financial intermediation, market failure

JEL Classification: G10, G28

Suggested Citation

Allen, Franklin and Carletti, Elena, Financial System: Shock Absorber or Amplifier? (July 2008). BIS Working Paper No. 257. Available at SSRN: https://ssrn.com/abstract=1165642 or http://dx.doi.org/10.2139/ssrn.1165642

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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