Banking and Markets
Posted: 22 Jan 2002
A complex financial system comprises both financial markets and financial institutions. Financial institutions can take the form of intermediaries or banks. Bank-based financial systems unlike intermediary-based systems, are subject to crises, but crises do not imply market failure. We show that a sophisticated financial system - a system with complete markets for aggregate risk and limited market participation - is incentive-efficient, if the institutions take the form of intermediaries, or else constrained-efficient, if they take the form of banks. We also consider an economy in which the markets for aggregate risks are incomplete. In this context, there is a role for prudential regulation: regulating liquidity can improve welfare.
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