Market failures in market-based finance

Giovanni di Iasio () and Dominika Kryczka

No 2545, Working Paper Series from European Central Bank

Abstract: We build a three-period model to investigate market failures in the market-based financial system. Institutional investors (IIs), such as insurance companies and pension funds, have liabilities offering guaranteed returns and operate under a risk-sensitive solvency constraint. They seek to allocate funds to asset managers (AMs) that provide diversification when investing in risky assets. At the interim date, AMs that run investment funds face investor redemptions and liquidate risky assets and/or deplete cash holdings, if available. Dealer banks can purchase risky assets, thus providing market liquidity. The latter ultimately determines equilibrium allocations. In the competitive equilibrium, AMs suffer from a pecuniary externality and hold inefficiently low amounts of cash. Asset fire sales increase the overall cost of meeting redemptions and depress risk-adjusted returns delivered by AMs to IIs, forcing the latter to de-risk. We show that a macroprudential approach to (i) the liquidity regulation of AMs and (ii) the solvency regulation of IIs can improve upon the competitive equilibrium allocations. JEL Classification: D62, G01, G23, G38

Keywords: insurance companies and pension funds; investment funds; market-based finance; market liquidity; regulation (search for similar items in EconPapers)
Date: 2021-05
New Economics Papers: this item is included in nep-cba, nep-cwa and nep-ias
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

Downloads: (external link)
https://www.ecb.europa.eu//pub/pdf/scpwps/ecb.wp2545~8556624017.en.pdf (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:ecb:ecbwps:20212545

Access Statistics for this paper

More papers in Working Paper Series from European Central Bank 60640 Frankfurt am Main, Germany. Contact information at EDIRC.
Bibliographic data for series maintained by Official Publications ().