FRICTIONS: Frictions in the Financial System

December, 2013 to November, 2018
EU FP7 - ERC Starting Grant

The financial crisis, since its start in 2008 has exposed enormous fractures both in the financial architecture and in the structure of the global economy. Although with some notable exceptions, the magnitude of the events caught the finance profession largely by surprise. Clearly, we have to understand better the institutional mechanism channelling savings towards the best uses of capital, and to what extent this mechanism can sometimes fail. The projects in this proposal will push the boundaries of our knowledge in this direction.I suggest a dual approach to achieve this goal. First, we have to improve our understanding of which frictions are the crucial impediments of the efficient functioning of markets. As this approach focuses on particular markets in isolation, I call this the micro approach. I propose three projects within this approach: trading and information diffusion in OTC markets, the crowdedness in limits-to-arbitrage, and the interaction of political uncertainty and sovereign bond prices.Second, from the frictions emerging from the micro approach, we have to select the ones which determine the aggregate liquidity fluctuations in the economy. I use this concept in a broad sense; referring to the changing efficiency with which the financial system allocates resources across investment opportunities. As this approach focuses on the functionality of the financial system as a whole, I call this the macro approach. I propose two projects within this approach. The first project focuses on the determinants of the differences in the financial architecture of different economies. It builds a novel framework to study the dynamics of the financial sector of an economy. The second project studies the role of shadow banking in the fluctuation of aggregate liquidity. In particular, this project concentrates on the fluctuation of the efficiency of private liquidity creation as the state of the economy changes.