According to the Liquidity Preference Theory, every person would like to hold cash and prefer liquid assets. It is this liquidity preference which makes people to hold cash rather than claims against others.
When we apply this theory to the intertemporal markets, given the abstractions of asymmetric information as well as the illiquidity of longer-term investments, it will lead to asymmetric knowledge of the quality of assets in overall bank portfolios. Under such circumstances, it is possible to make a case for a non-market entity which acts as a planner that solves the second-best risk-sharing problem.
The ex-ante optimum cannot be attained by unfettered strategic interactions across privately motivated agents. Only welfare-maximizing agents like the central Bank subject to resource and incentive constraints but with ex-ante commitment will suffice.
Read More in: Theory of Public Finance
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