Financial Intermediaries and Markets

Abstract

A complex financial system comprises both financial markets and financial intermediaries. We distinguish financial intermediaries according to whether they issue complete contingent contracts or incomplete contracts. Intermediaries such as banks that issue incomplete con-tracts, e.g., demand deposits, are subject to runs, but this does not imply a market failure. A sophisticated financial system–a system with complete markets for aggregate risk and limited market participation–is incentive-efficient, if the intermediaries issue complete con-tingent contracts, or else constrained-efficient, if they issue incomplete contracts. We argue that there may be a role for regulating liquidity provision in an economy in which markets for aggregate risks are incomplete. 1 Markets, intermediaries and crises For a long time, it has been taken as axiomatic that financial crises are best avoided. We confront this conventional wisdom by showing that, under certain conditions, a laisser-faire financial system achieves the incentive-efficient or constrained-efficient allocation.1 Further-more, constrained efficiency may require financial crises in equilibrium. The assumptions