A Welfare Analysis of Segmented Liquidity Markets

59 Pages Posted: 15 Mar 2012 Last revised: 12 Apr 2017

See all articles by Alexander Guembel

Alexander Guembel

Toulouse School of Economics, University of Toulouse Capitole

Oren Sussman

University of Oxford - Said Business School; Ben-Gurion University of the Negev; University of London; University of Oxford - Said Business School

Date Written: April 11, 2017

Abstract

The 2008 financial crisis heightened concerns about contagion across high leverage investors. Some have suggested that segmenting markets into stand alone units may contribute to financial stability and enhance social welfare. We provide a welfare analysis of segmentation policies in a two country model with endogenous financial crises and cross country contagion due to fire sales externalities. We model a continuous shock to liquidity demand in each country, which allows us to distinguish between crises, depending on their severity and endogenize crisis probabilities. We identify a new trade-off created by segmentation decisions. When countries segment, they are protected from contagion when their shocks are mild, but exposed to crisis when shocks are large and access to a neighbor's liquidity is denied. This trade-off reduces welfare. We also show that segmentation only affects crisis probabilities when governments inject public liquidity. Then and only then can segmentation be welfare enhancing. Finally, failure to coordinate policies may lead to excessive segmentation when governments are involved in liquidity injection, but not when liquidity is provided solely privately.

Keywords: Contagion, fire sales, market integration, financial crisis, liquidity injection

JEL Classification: F32, G01

Suggested Citation

Guembel, Alexander and Sussman, Oren, A Welfare Analysis of Segmented Liquidity Markets (April 11, 2017). Available at SSRN: https://ssrn.com/abstract=2022086 or http://dx.doi.org/10.2139/ssrn.2022086

Alexander Guembel (Contact Author)

Toulouse School of Economics, University of Toulouse Capitole ( email )

Manufacture des Tabacs
21, allee de Brienne
Toulouse, 31000
France

Oren Sussman

University of Oxford - Said Business School ( email )

Park End Street
Oxford, OX1 1HP
Great Britain
+44 1865 288 926 (Phone)
+44 1865 288 805 (Fax)

Ben-Gurion University of the Negev

1 Ben-Gurion Blvd
Beer-Sheva 84105, 84105
ISRAEL

University of London ( email )

Sussex Place
Regent's Park
London, London NW1 4SA
United Kingdom

University of Oxford - Said Business School ( email )

Park End Street
Oxford, OX1 1HP
Great Britain
+44 1865 288 926 (Phone)
+44 1865 288 805 (Fax)

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