A Welfare Analysis of Segmented Liquidity Markets

The 2008 financial crisis heightened concerns about contagion across high leverage investors. Some have suggested that segmenting markets into stand alone units may contribute to financial stability and enhance social welfare. We provide a welfare analysis of segmentation policies in a two country model with endogenous financial crises and cross-country contagion due to fire sales externalities. We model a continuous shock to liquidity demand in each country, which allows us to distinguish between crises, depending on their severity and endogenize crisis probabilities. We identify a new trade-off created by segmentation decisions. When countries segment, they are protected from contagion when their shocks are mild, but exposed to crisis when shocks are large and access to a neighbor's liquidity is denied. This trade-off reduces welfare. We also show that segmentation only affects crisis probabilities when governments inject public liquidity. Then and only then can segmentation be welfare enhancing. Finally, failure to coordinate policies may lead to excessive segmentation when governments are involved in liquidity injection, but not when liquidity is provided solely privately.