Liquidity and Ambiguity: Banks or Asset Markets?

We study the impact of ambiguity on financial intermediation in an economy where agents have random liquidity needs. The ambiguity the agents face is modeled by the degree of confidence in their additive beliefs. We compare an optimal liquidity allocation with the allocation achieved by trade in an asset market, by a mutual fund, and by a competitive banking sector. For low levels of confidence, intermediation is superfluous. For intermediate levels the asset market, and for high levels of confidence banks are the preferred intermediary arrangements. The desirability of mutual funds depends crucially on the possibility of short sales. When short selling of fund shares is feasible, the asset market outcome results. If short sales are impossible, then a mutual fund can implement the optimal outcome for any degree of confidence.