Financial Fragility and Over-the-Counter Markets

Posted: 14 Apr 2016

See all articles by Bruno Sultanum

Bruno Sultanum

Federal Reserve Banks - Federal Reserve Bank of Richmond

Date Written: 2016-04-13

Abstract

This paper studies the interaction between financial fragility and over-the-counter markets. In the model, the financial sector is composed of a large number of investors divided into different groups, which are interpreted as financial institutions, and a large number of dealers. Financial institutions and dealers trade assets in an over-the-counter market à la Duffie et al. (2005) and Lagos and Rocheteau (2009). Investors are subject to privately observed preference shocks, and financial institutions use the balanced team mechanism, proposed by Athey and Segal (2013), to implement an efficient risk-sharing arrangement among its investors. I show that when the market is more liquid, in the sense that the searchfriction is mild, the economy is more likely to have a unique equilibrium and, therefore, is not fragile. However, when the search friction is severe, I provide examples with run equilibria — where investors announce low valuation of assets because they believe everyone else in their financial institution is doing the same. In terms of welfare, I find that, conditional on bank runs existing, the welfare impact of the search friction is ambiguous. The reason is that, during runs, trade is inefficient and, as a result, a friction that reduces trade during runs has the potential to improve welfare. This result is in sharp contrast with the existing literature which suggests that search friction has a negative impact on welfare.

JEL Classification: D82, E58, G01, G21

Suggested Citation

Sultanum, Bruno, Financial Fragility and Over-the-Counter Markets (2016-04-13). FRB Richmond Working Paper No. 16-4. Available at SSRN: https://ssrn.com/abstract=2764779

Bruno Sultanum (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Richmond ( email )

P.O. Box 27622
Richmond, VA 23261
United States

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