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Market failures in market-based finance

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  • di Iasio, Giovanni
  • Kryczka, Dominika

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

Suggested Citation

  • di Iasio, Giovanni & Kryczka, Dominika, 2021. "Market failures in market-based finance," Working Paper Series 2545, European Central Bank.
    • Handle: RePEc:ecb:ecbwps:20212545
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    References listed on IDEAS

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    Cited by:

    1. Giovanni di Iasio & Spyridon Alogoskoufis & Simon Kordel & Dominika Kryczka & Giulio Nicoletti & Nicholas Vause, 2022. "A model of system-wide stress simulation: market-based finance and the Covid-19 event," Questioni di Economia e Finanza (Occasional Papers) 687, Bank of Italy, Economic Research and International Relations Area.
    2. di Iasio, Giovanni & Kaufmann, Christoph & Wicknig, Florian, 2022. "Macroprudential regulation of investment funds," Working Paper Series 2695, European Central Bank.

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    More about this item

    Keywords

    insurance companies and pension funds; investment funds; market-based finance; market liquidity; regulation;
    All these keywords.

    JEL classification:

    • D62 - Microeconomics - - Welfare Economics - - - Externalities
    • G01 - Financial Economics - - General - - - Financial Crises
    • G23 - Financial Economics - - Financial Institutions and Services - - - Non-bank Financial Institutions; Financial Instruments; Institutional Investors
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation

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