A Theory of Liquidity and Regulation of Financial Intermediation

Emmanuel Farhi, Mikhail Golosov, Aleh Tsyvinski

NBER Working Paper No. 12959
Issued in March 2007
NBER Program(s):Economic Fluctuations and Growth, Monetary Economics, Asset Pricing

This paper studies a mechanism design model of financial intermediation. There are two informational frictions: agents receive unobservable shocks and can participate in markets by engaging in trades unobservable to intermediaries. Without regulations, intermediaries provide no risk sharing because of an externality arising from arbitrage opportunities. We identify a simple regulation -- a liquidity requirement -- that corrects such an externality by affecting the interest rate on the markets. We characterize the form of the optimal liquidity adequacy requirement for a general class of preferences. We show that whether markets underprovide or overprovide liquidity, and whether a liquidity cap or a liquidity floor should be used depends on the nature of the shocks that agents experience. Moreover, we prove that the optimal liquidity adequacy requirement implements a constrained efficient allocation subject to unobservable types and trades. We provide closed form solutions for the optimal liquidity requirement and welfare gains of imposing such requirements for two important special cases. In contrast with the existing literature, the necessity of regulation does not depend on exogenous incompleteness of markets for aggregate shocks.

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Document Object Identifier (DOI): 10.3386/w12959

Published: Emmanuel Farhi & Mikhail Golosov & Aleh Tsyvinski, 2009. "A Theory of Liquidity and Regulation of Financial Intermediation," Review of Economic Studies, Blackwell Publishing, vol. 76(3), pages 973-992, 07. citation courtesy of

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