A Theory of Liquidity and Regulation of Financial Intermediation

This paper studies a Diamond-Dybvig model of …nancial intermediation providing insurance against unobservable liquidity shocks in the presence of unobservable trades on private markets. We show that in this case competitive equilibria are ine¢ cient. A social planner …nds it bene…cial to introduce a wedge between the interest rate implicit in optimal allocations and the economy’s marginal rate of transformation. This improves risk-sharing by reducing the attractiveness of joint deviations where agents simultaneously misrepresent their type and engage in trades on private markets. We propose a simple implementation of the optimum that imposes a constraint on the portfolio share that …nancial intermediaries need to invest in short-term assets. In the case of Diamond-Dybvig preferences, the optimal allocation coincides with the unconstrained optimum. For more general preferences, the optimal allocation does not coincide with the unconstrained optimum, and the direction of the policy intervention depends on the nature of the shocks in a manner that we precisely characterize.