In the last chapter, we examined the role of intermediaries as providers of liquidity and risk sharing. We did so under the assumption that intermediaries operated in isolation. There were no other financial institutions and no financial markets. In the present chapter, by contrast, we restrict our attention to asset markets and assume that there are no financial institutions. In the chapters that follow, we use the building blocks developed in these two chapters to study economies in which financial intermediaries and financial markets coexist and interact with each other. Financial markets allow intermediaries to hedge risks and to obtain liquidity by selling assets, but this can be a mixed blessing. In some contexts, markets allow intermediaries to achieve superior risk sharing, but in others they lead to increased instability. To understand how markets can destabilize financial intermediaries, we first need to understand the relationship between market liquidity and asset-price volatility. This is an interesting topic in its own right. Its implications for the stability of the financial system will become clear in the next chapter.
One of the most striking things about stock markets is the degree of price volatility. On any given day it is common for the largest movement of an individual stock to be around 25 percent. The total market often moves by one or two percent. In October 1987 the market fell by around a third in a single day. These large changes in prices can trigger financial instability. This is particularly true in modern financial systems where many institutions undertake complex risk management programs. Understanding asset price volatility is thus an important component of understanding financial crises. In this chapter we focus on asset markets alone. In the next chapter we will look at the interaction of markets and financial institutions and see how the effects investigated here can lead to fragility.