Financial Instability

In this chapter, the central bank is put aside and we review simple models of financial instability, which will be the basis for the subsequent chapter to explain the role of the central bank as lender of last resort. We first recall that financial instability is mostly triggered by a negative shock on asset prices, and thereby on the solvency of debtors, which in turn worsens access to credit and can set in motion a liquidity crisis with vicious circles. We develop the concepts of solvency “conditional” and “unconditional” on liquidity: a decline in asset prices can lead an unconditionally solvent debtor to become only conditionally solvent, such that sufficient liquidity becomes decisive for preventing its default. We then apply these concepts to the stability of bank funding and introduce the problem of bank runs. We subsequently show why asset liquidity in a dealer market deteriorates during a financial crisis (increased volatility and uncertainty increase the required bid-ask spread); how asymmetric information can lead to a freeze of credit markets in a simple adverse selection model; how declining and more volatile asset prices drive increases of haircut, and how these can force fire sales and defaults of borrowers. We finally discuss the interaction between these various crisis channels.

Frictional Intermediation in Over-the-Counter Markets

We extend Duffie et al.’s (2005) search-theoretic model of over-the-counter (OTC) asset markets, allowing for a decentralized inter-dealer market with arbitrary heterogeneity in dealers’ valuations (or, equivalently, inventory costs). We develop a solution technique that makes the model fully tractable and allows us to derive, in closed form, theoretical formulas for key statistics analysed in empirical studies of the intermediation process in OTC markets. A calibration to the market for municipal bonds allows us to quantify important unobservable characteristics of this market, including the severity of search and bargaining frictions and the nature of heterogeneity across dealers. We use our calibrated model to study the effect of these market characteristics on total welfare and the distribution of gains from trade across customers and dealers.