Liquidity creation without banks
I revisit the Diamond-Dybvig model of liquidity insurance in the presence of hidden trades. The key result is that in this environment deposit-taking banks are not necessary for the efficient provision of liquidity. Mutual funds are constrained efficient when supplemented with the same government liquidity regulation that is required to make a banking system constrained efficient. However, whereas banks are potentially subject to costly panics, mutual funds are not run-prone and hence superior from a welfare perspective if runs happen with a non-zero probability.
Keywords: liquidity creation, liquidity insurance, hidden trades, bank runs, mutual funds, narrow banking, financial stability.
JEL classifications: D91, E61, G21, G23, G28.
Working paper no. 482
- Simas Kucinskas