Synamic banking: a reconsideration

Financially intermediated and stock market consumption-investmentallocations, with and without governmental interventions, arecompared in a welfare sense in overlapping generation economieswith (and without) shocks to agents' intertemporal preferences.We first show that, in economies with preference shocks, governmentalinterventions subject to the same information requirements asthose imposed on financial intermediaries, lead to stock marketallocations that are not inferior to those attained under financialintermediation. Second, we argue that the necessary interventionsare qualitatively no different from those required to implementstationary optimal allocations in OLG models without shocksto agents' intertemporal consumption preferences.     

Insurance-adjusted valuation,decision making,and capital return

Although the insurance industry has a significant economic role, few theoretical studies link insurance with the overlapping generations economy. This study suggests a new overlapping generations model that includes insurance in the agents' economic decisions under the uncertainty of financial losses. In this insurance model, we derive risk-averse workers' optimal insurance purchases and consumption based on the insurance-adjusted valuations, which are the present value of the income streams minus insurance premiums paid in the future. The theoretical equilibrium model predicts capital returns, wealth, labor supply, etc. Our findings show that higher workforce and technological progress increase private insurance demand and reduce the capital-output ratio, and higher losses as a fraction of output increase social insurance demand and reduce the capital-output ratio via numerical comparative statics.     

Financial Intermediaries, Markets, and Growth

We build a model in which financial intermediaries provide insurance to households against idiosyncratic liquidity shocks. Households can invest in financial markets directly if they pay a cost. In equilibrium, the ability of intermediaries to share risk is constrained by the market. From a growth perspective, this can be beneficial because intermediaries invest less in the productive technology when they provide more risk-sharing. Our model predicts that bank-oriented economies can grow more slowly than more market-oriented economies, which is consistent with some recent empirical evidence.     

Competition among Financial Intermediaries When Diversification Matters

Many models predict that the diversification and efficiency of financial intermediaries (“banks”) increases with their size, so that a relatively unrestricted banking sector will settle into an equilibrium with several large, well-diversified, and competitive banks. However, this prediction is at odds with the actual pattern of unrestricted banking sector evolution in many countries. I develop a model that motivates this actual pattern and examine the model's implications for regulatory policy. I show that an investor's return from a bank depends on the number of investors using that bank; this adoption externality makes investor beliefs about other investors' actions critical for bank competition. In a young banking system with free entry, coordination problems lead to excessive fragmentation, and debt overhang makes it difficult for small banks to capture additional market share. As the system matures, many banks fail, and the survivors become the focus of investor beliefs; these incumbents gain a strong advantage over entrants, facilitating collusion. Entry restrictions reduce fragmentation but aid collusion, while government insurance for investors reduces incumbency advantage and collusion but may cause excessive fragmentation. Thus, regulators may wish to impose temporary entry restrictions, along with partial insurance. These results are consistent with historical evidence from several countries.Journal of Economic LiteratureClassification Numbers: G21, G22, L13.     

Credit evaluation,information production,and financial intermediation

Financial intermediaries such as banks, saving and loan institutions, and insurance companies play a large and important role in highly developed economies. The economic significance of financial intermediaries results from their making arrangements between borrowers and lenders more efficiently than if these agents had to trade directly. The intent of this article is to provide a better understanding of the advantage that a financial institution has over an individual lender. This research treats intermediaries as producers of information in the credit evaluation process. The lender produces borrower information that revises the expected profit of the credit decision. Though the production of credit itself holds no economic advantage for institutions over individuals. The opportunity to produce information will provide economies of scale in lending and will help to explain the existence of financial intermediaries.     

Anonymous markets and monetary trading

We study infinite-horizon monetary economies characterized by trading frictions that originate from random pairwise meetings, and commitment and enforcement limitations. We prove that introducing occasional trade in ‘centralized markets’ opens the door to an informal enforcement scheme that sustains a non-monetary efficient allocation. All is required is that trading partners be patient and their actions be observable. We then present a matching environment in which trade may occur in large markets and yet agents’ trading paths cross at most once. This allows the construction of models in which infinitely lived agents trade in competitive markets where money plays an essential role.     

Phasing out the GSEs

We develop a new model of the mortgage market that emphasizes the role of the financial sector and the government. Risk tolerant savers act as intermediaries between risk averse depositors and impatient borrowers. Both borrowers and intermediaries can default. The government provides both mortgage guarantees and deposit insurance. Underpriced government mortgage guarantees lead to more and riskier mortgage originations and higher financial sector leverage. Mortgage crises occasionally turn into financial crises and government bailouts due to the fragility of the intermediaries’ balance sheets. Foreclosure crises beget fiscal uncertainty, further disrupting the optimal allocation of risk in the economy. Increasing the price of the mortgage guarantee “crowds in” the private sector, reduces financial fragility, leads to fewer but safer mortgages, lowers house prices, and raises mortgage and risk-free interest rates. Due to a more robust financial sector and less fiscal uncertainty, consumption smoothing improves and foreclosure rates fall. While borrowers are nearly indifferent to a world with or without mortgage guarantees, savers are substantially better off. While aggregate welfare increases, so does wealth inequality.     

Competitive risk sharing contracts with one-sided commitment

This paper analyzes dynamic equilibrium risk sharing contracts between profit-maximizing intermediaries and a large pool of ex ante identical agents that face idiosyncratic income uncertainty that makes them heterogeneous ex post. In any given period, after having observed her income, the agent can walk away from the contract, while the intermediary cannot, i.e. there is one-sided commitment. We consider the extreme scenario that the agents face no costs to walking away, and can sign up with any competing intermediary without any reputational losses. We demonstrate that not only autarky, but also partial and full insurance can obtain, depending on the relative patience of agents and financial intermediaries. Insurance can be provided because in an equilibrium contract an up-front payment effectively locks in the agent with an intermediary. We then show that our contract economy is equivalent to a consumption-savings economy with one-period Arrow securities and a short-sale constraint, similar to Bulow and Rogoff [1989. Sovereign debt: is to forgive to forget? American Economic Review 79, 43-50]. From this equivalence and our characterization of dynamic contracts it immediately follows that without cost of switching financial intermediaries debt contracts are not sustainable, even though a risk allocation superior to autarky can be achieved.     

Dynamic Spanning in the Consumption-Based Capital Asset Pricing Model

Under the assumptions of the Consumption-based Capital Asset Pricing Model (CCAPM), Pareto optimal consumption allocations are characterized by each agent's consumption process being adapted to the filtration generated by the aggregate consumption process of the economy. The wealth processes of the agents, however, are adapted to the finer filtration generated by aggregate consumption and the conditional distribution of future aggregate consumption. Therefore, in order to achieve Pareto optimal consumption allocations, a sufficiently varied set of assets must exist such that any wealth process adapted to this finer filtration can be implemented by dynamically trading in that set of assets. We provide sufficient conditions for the existence of such a set of assets based on dynamically trading contingent claims on aggregate consumption. In addition, we give sufficient conditions for the existence of equilibria in a dynamically effectively complete market in which agents are only able to trade in contingent claims on aggregate consumption, the market portfolio of firms, and a (numeraire) zero-coupon bond. We demonstrate the role of short- and long-term contingent claims on aggregate consumption for the implementation of Pareto optimal allocations in the presence of short- andlong-term risks. In addition, in the presence of personal risks, we demonstrate the role of insurance contracts.     

Banking Competition,Collateral Constraints,and Optimal Monetary Policy

We analyze optimal monetary policy in a model with two distinct financial frictions: monopolistically competitive banks that charge endogenous lending spreads, and collateral constraints. We show that welfare maximization is equivalent to stabilization of four goals: inflation, output gap, the “consumption gap” between borrowers and savers, and a “housing gap” that measures the distortion in the distribution of the collateralizable asset between both groups. Collateral constraints create a trade‐off between stabilization goals. Following both productivity and financial shocks, and relative to strict inflation targeting, the optimal policy implies sharper movements in the policy rate, aimed primarily at reducing fluctuations in asset prices and hence in borrowers' net worth. The policy trade‐offs become amplified as banking competition increases, due to the fall in lending spreads and the resulting increase in borrowers' leverage.     

Diversification disasters

The recent financial crisis has revealed significant externalities and systemic risks that arise from the interconnectedness of financial intermediaries’ risk portfolios. We develop a model in which the negative externality arises because intermediaries’ actions to diversify that are optimal for individual intermediaries may prove to be suboptimal for society. We show that the externality depends critically on the distributional properties of the risks. The optimal social outcome involves less risk-sharing, but also a lower probability for massive collapses of intermediaries. We derive the exact conditions under which risk-sharing restrictions create a socially preferable outcome. Our analysis has implications for regulation of financial institutions and risk management.     

Debt Financing,Corporate Financial Intermediaries and Firm Valuation

In this paper we consider the role of financial intermediaries in the valuation of firms and projects. We show that security prices should reflect both used and unused debt capacity if some corporations can act as financial intermediaries and can capture the tax benefits of debt capacity unused by the operating firm. We also provide some reasons why the value of the firm might be increased if the financing and operating risks of the firm are separated and financial intermediaries issue debt rather than the unit operating the asset.     

Interaction between economic and financial development

This paper presents a model of financial and economic development which assumes the consumption of real resources by the financial sector. Financial development occurs endogenously as the economy reaches a critical threshold of economic development. Compared to financial autarky, financial intermediaries allocate savings, net of their costs of operation, to more productive investments. Whenever the technology financed by intermediaries is more capital-intensive than that operated in financial autarky, the growth effect of financial development is ambiguous. As a result, financial development may be unsustainable. However, when financial development is sustainable, the credit market becomes more competitive and more efficient over time, and this could eventually contribute to economic growth. Nonetheless, given monopolistic competition in the financial sector, the level of entry into the credit market is generally inefficient. For instance, with diminishing returns to specialisation, entrants might be too few at the early stages of economic development and too many later on.     

PORTFOLIO CHOICES,CONSUMPTION, AND PRICES IN A MARKET WITH DURABLE ASSETS

Recent research in investments has focused almost exclusively on financial assets such as corporate stocks. Although durable assets constitute an important part of investors' holdings, little effort has been made to explore their role in individuals' investments decisions and on assets pricing. This paper establishes results concerning the role of durable assets in the determination of optimum portfolio choices. The paper explores the effect of consumption considerations related to the service flows generated by durable assets on optimum portfolio considerations and asset prices. The main result is tied to the existence, or lack thereof, of efficient rental markets. In the absence of rental markets (or with restrictions on renting), investors' portfolio choices are not independent of consumption considerations as they are assumed to be in the standard CAPM. Individuals may thus hold different portfolios, and prices reflect the owner's inability to trade consumption flows. Under perfect market assumptions with unrestricted rental markets, optimum portfolio choices are undistinguishable from those implied by the standard CAPM in the sense that they are mean-variance efficient and identical for all individuals. Consumption is adjusted by trading service flows in the rental market. Prices, and the price of risk, however, reflect the existence of durable assets service flows as well as the risks involved in trading these flows in the rental market. In the model, risky rental income is introduced by uncertain rental costs. Equilibrium rental rates, an important part of the return expected from holding durable assets, are determined in the context of the mean-variance framework as a function of return and undiversifiable risk.     

On the Positive Role of Financial Intermediation in Allocation of Venture Capital in a Market with Imperfect Information

This paper develops a theory of financial intermediation that highlights the contribution of intermediaries as informed agents in a market with imperfect information. We consider a venture capital market where the entrepreneurs select the qualities of projects and their perquisite consumptions, about which the investors are imperfectly informed. It is shown that when all investors have positive search costs, the entrepreneurs are induced to offer the unacceptable inferior projects (“lemons” only), and the investors will not enter the venture capital market, but put their funds in other low return investments–an undesirable allocation of resources. Beginning with an initial undesirable situation, the financial intermediaries may evolve as informed agents that induce a Pareto-preferred allocation, leading the investors to a higher welfare state. We focus our analysis on the existence of intermediation equilibra when the market for intermediation services is competitive. The distribution of returns on projects, the fees charged by intermediaries, and the fraction of institutional holdings are all endogenous in equilibrium. It is shown that (i) there cannot be a competitive intermediation equilibrium with very high institutional holdings, and (ii) in other cases multiple equilibra may exist, but the one with the highest institutional holdings dominates the others in a Pareto sense.     

Flight to liquidity and the Great Recession

This paper argues that counter-cyclical liquidity hoarding by financial intermediaries may strongly amplify business cycles. It develops a dynamic stochastic general equilibrium model in which banks operate subject to agency problems and funding liquidity risk in their intermediation activity. Importantly, the amount of liquidity reserves held in the financial sector is determined endogenously: Balance sheet constraints force banks to trade off insurance against funding outflows with loan scale. A financial crisis, simulated as an abrupt decline in the collateral value of bank assets, triggers a flight to liquidity, which strongly amplifies the initial shock and induces credit crunch dynamics sharing key features with the Great Recession. The paper thus develops a new balance sheet channel of shock transmission that works through the composition of banks’ asset portfolios.     

Geographic diversification and firm value in the financial services industry

This paper investigates whether geographic diversification is value-enhancing or value-destroying in the financial services sector, broadly defined. Our dataset comprises approximately 3579 observations over the period from 1985 to 2004 and covers the entire range of U.S. financial intermediaries — commercial banks, investment banks, insurance companies, asset managers, and financial infrastructure services firms. We use two alternative measures of geographic diversification: (1) a dummy variable whether the firm reports more than one geographic segment and (2) the percentage of sales from non-domestic operations. Our results indicate that geographic diversification is not associated with a significant valuation discount in financial intermediaries. However, when accounting for the firms' main activity-areas, we find evidence of a significant discount associated with geographic diversification in securities firms and a premium in credit intermediaries and insurance companies. All these results are robust after taking into account functional diversification of the firms, a potential endogeneity of both functional and geographic diversification, and a potential value transfer from equity to debt holders by using estimates of the market value of debt.     

Piggy Banks: Financial Intermediaries as a Commitment to Save

Banks and other intermediaries may help savers commit to investment plans that savers could not stick to if they held assets directly. We illustrate this commitment function using a version of the Diamond and Dybvig (1983) model where savers’ short-run liquidity needs are correlated with shocks to investment opportunities. The investment securities are all freely tradeable, yet savers still do better if they delegate their investment decisions to an intermediary that overrides the savers’ liquidity demands when investment opportunities warrant. Bank CDs, insurance annuities, pensions, and even social security, by locking funds out of reach, may all constitute real world examples of this commitment role of financial intermediaries.     

Does the strength of the legal systems matter for trade in insurance and financial services?

This paper investigates if the strength of the legal system impacts on the trade in insurance and financial services in the high-income OECD and developing countries. Our findings reveal a statistically significant positive correlation of rule of law and regulatory quality with the exports and imports of insurance and financial services. Our empirical findings also reveal a negative and statistically significant correlation of contract enforcement with the exports and imports of insurance and financial services. We conclude that strengthening the rule of law and contract enforcement mechanisms can facilitate higher levels of trade in insurance and financial services.     

Consumption Externality and Equilibrium Underinsurance

Relative consumption has been found to be crucial in many areas, such as asset pricing, the design of taxation, and economic growth. This article extends this line of research to the individual's insurance decision. We first define “keeping up with the Joneses” in the purchase of insurance and find that jealousy does not necessarily give rise to “keeping up with the Joneses.” We also identify several sufficient conditions that cause the optimal coverage in the private market to be less than the social optimum (equilibrium underinsurance). Jealousy is found to be neither a sufficient nor a necessary condition for equilibrium underinsurance. We further show that a social welfare maximizing government could adopt a tax system to correct for the consumption externality and make individuals better off.