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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.
November 21, 2007.
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