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The banking sector is one of the most highly regulated sectors in the economy. However, in contrast to other regulated sectors there is no wide agreement on the market failures that justify regulation. We suggest that there are two important ones. The first is a coordination problem that arises because of multiple equilibria. If people believe there is going to be a panic then that can be self-fulfilling. If they believe there will be no panic then that can also be self-fulfilling. Policy analysis is difficult in this case because our knowledge of equilibrium selection mechanisms is limited. Global games represent one promising modeling technique but as yet there is very little empirical evidence in support of this approach. The second market failure is that if there are incomplete markets the provision of liquidity is inefficient. In particular there must be significant price volatility in order for the providers of liquidity to earn the opportunity cost of holding liquidity. We argue that financial fragility, contagion, and asset price bubbles are manifestations of poor liquidity provision. In the absence of a market failure the financial system acts as a shock absorber. However, if there is a market failure it can be an amplifier.

Financial System: Shock Absorber or Amplifier?