Financial fragility and over-the-counter markets

This paper studies the interaction between financial fragility and over-the-counter (OTC) markets. I model the financial sector as a large number of investors divided into different groups, which I interpret as financial institutions, and a large number of dealers. Financial institutions and dealers trade assets in an OTC market à la Duffie et al. (2005) and Lagos and Rocheteau (2009). Investors receive 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 their investors. When the market is liquid, in the sense that search and bargaining are small frictions, I show that the economy is likely to have a unique equilibrium and, therefore, is not fragile. When these frictions are severe, a run equilibrium exists—investors announce low valuation of assets because they believe everyone else in their financial institution is doing the same. Conditional on bank runs existing, the welfare impact of the search friction is ambiguous. 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.