"We should take care not to make the intellect our god; it has, of course, powerful muscles, but no personality."
--- Albert Einstein.
ABSTRACT: This paper studies the interaction between financial fragility and over-the-countermarkets. 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 search friction 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 runequilibria---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, conditionalon bank runs existing, the welfare impact of the search friction is ambiguous. The reasonis 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.
ABSTRACT: We study trading in over-the-counter (OTC) markets where agents have heterogeneous and private valuations for assets. We develop a quantitative model in which assets are issued through a primary market and then traded in a secondary OTC market. Then we use data on the US municipal bond market to calibrate the model. We find that the effects of private information are large, reducing asset supply by 20%, trade volume by 80%, and aggregate welfare by 8%. Using the model, we identify two channels through which the information friction harms the economy. First, the distribution of the existing stock of assets is inefficient because some of the efficient trades, which should occur, do not. Second, the total stock of assets is inefficiently low because resale value and liquidity go down due to the information friction. We investigate how much a simple tax/subsidy scheme that spurs issuance of new assets can help mitigate the cost associated with private information and find that it lowers the welfare cost from 8% to approximately 1%.
ABSTRACT: This paper studies the optimal design of a liability-sharing arrangement as an infinitely repeated game. We construct a schematic, non-cooperative, 2-player model. The active agent can take a costly, unobservable action to try to avert a crisis. Whenever a crisis occurs, each agent decides unilaterally how much to contribute mitigating it. For the one-shot game, when the avoidance cost is too high relative to the expected loss of crisis for the active agent, the first-best cannot be supported as a static Nash equilibrium. We show that with the same stage-game environment, the first-best cannot be implemented as a perfect public equilibrium (PPE) of the infinitely repeated game either. Instead, at any Pareto efficient PPE, the active agent “shirks” infinitely often, and when crisis happens, the active agent is “bailed out” infinitely often. The frequencies of crisis and bailout are endogenously determined at equilibrium. This result of welfare-improving equilibrium crises and bailouts is consistent with historical episodes of more/less frequent crises and bailout/no bailout for troubled institutions and countries in the real economy. We explore some comparative statics of the repeated game numerically.