TY - JOUR AU - Farhi,Emmanuel AU - Golosov,Mikhail AU - Tsyvinski,Aleh TI - A Theory of Liquidity and Regulation of Financial Intermediation JF - National Bureau of Economic Research Working Paper Series VL - No. 12959 PY - 2007 Y2 - March 2007 UR - http://www.nber.org/papers/w12959 L1 - http://www.nber.org/papers/w12959.pdf N1 - Author contact info: Emmanuel Farhi Harvard University Department of Economics Littauer Center Cambridge, MA 02138 Tel: 617/496-1835 Fax: 617/495-8570 E-Mail: efarhi@harvard.edu Mikhail Golosov Department of Economics Princeton University 111 Fisher Hall Princeton, NJ 08544 Tel: 609/258-4003 Fax: 609/258-6419 E-Mail: golosov@princeton.edu Aleh Tsyvinski Department of Economics Yale University Box 208268 New Haven, CT 06520-8268 E-Mail: a.tsyvinski@yale.edu AB - 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. ER -