By Chao Gu, Cyril Monnet, Ed Nosal and Randall Wright
Are financial intermediaries inherently unstable? If so, why? What does this suggest about government intervention? To address these issues we analyze whether model economies with financial intermediation are particularly prone to multiple, cyclic, or stochastic equilibria. Four formalizations are considered: a dynamic version of Diamond-Dybvig banking incorporating reputational considerations; a model with delegated investment as in Diamond; one with bank liabilities serving as payment instruments similar to currency in Lagos- Wright; and one with Rubinstein-Wolinsky intermediaries in a decentralized asset market as in Duffie et al. In each case we find, for different reasons, financial intermediation engenders instability in a precise sense.
Do financial intermediaries bring instability to the economy? This is a quite fundamental question, and policy makers seem to have responded with the affirmative given the amount of regulation that this sector is subject to. Are they right? This paper seems to suggest so, as four popular models of financial intermediation indicate.