"We should take care not to make the intellect our god; it has, of course, powerful muscles, but no personality."
--- Albert Einstein.
ABSTRACT: We propose an information-based theory of financial intermediation. Investors are heterogeneous in what they know about their counterparties trade motivation. Better experts, that is, those who know more about their counterparties when bargaining, extract more rents and are more central to trade---composing the core of the core-periphery market structure widely documented in over-the-counter financial markets. Empirically, the model has two predictions that differ from alternative models of intermediation: (1) investors trade more when there is more information avaialable regarding their own trade needs; (2) this effect is less important when trading with more central investors. We combine trade reports on credit-default swaps with information on financial institutions that file the 13-F Form to test our results. The data is consistent with both our predictions. Firms that file the 13-F Form are more likely to trade in the weeks after the report than in the weeks before. Moreover, this effect is weaker when controling for the centrality of the firms' counterparties.
ABSTRACT: We model asset issuance in over-the-counter markets. Investors buy newly issued assets in a primary market and trade existing assets in a secondary market, where trade in both markets is over-the-counter (OTC). We show that the level of asset issuance and its efficiency depend on how investors split the surplus in secondary market trade. If buyers get most of the surplus, then sellers do not have incentives to participate in the primary market in order to intermediate assets and the economy has a low level of assets. On the other hand, if sellers get most of the surplus, buyers have strong incentives to participate in the primary market and the economy has a high level of assets. The decentralized equilibrium is inefficient for any splitting rule. The result follows from a double-sided hold-up problem in which it is impossible for all investors to take into account the full social value of an asset when trading. We propose a tax/subsidy scheme and show how it restores efficiency. We also extend the model in several dimensions and study the robustness of the inefficiency result. Finally, we explore the effects of the inefficiency using numerical examples. We study how bargaining power and trading speed in the secondary market affect the efficiency result, and we notice some interesting implications for policy interventions aimed to restore efficiency to OTC markets.
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.