This paper discusses the inherent instability in the current financial system. It arises from major movements in bank reserves and the creation of liquidity which can not be controlled significantly. As a result, increased laxity in lending criteria as banks compete with each other to find borrowers produces a decline in asset quality. It is the change in liquidity preferences of the banks which eventually leads them to stop liquidity creation, rather than the maturity mismatch, which causes fragility. The paper also discusses the available methods of dampening such instability in the financial system and the current constraints on them.
financial_markets (Download the full text in PDF format)