Econometrica: Jul, 2004, Volume 72, Issue 4
Financial Intermediaries and Markets
Franklin Allen, Douglas Gale
A complex financial system comprises both financial markets and financial intermediaries. We distinguish financial intermediaries according to whether they issue complete contingent contracts or incomplete contracts. Intermediaries such as banks that issue incomplete contracts, e.g., demand deposits, are subject to runs, but this does not imply a market failure. A sophisticated financial system—a system with complete markets for aggregate risk and limited market participation—is incentive‐efficient, if the intermediaries issue complete contingent contracts, or else constrained‐efficient, if they issue incomplete contracts. We argue that there may be a role for regulating liquidity provision in an economy in which markets for aggregate risks are incomplete.