Financial Intermediation and Allocative Efficiency

Financial Intermediation and Allocative Efficiency

• Financial intermediation plays a crucial role in allocating funds to projects with the highest marginal product of capital, leading to increased efficiency and economic growth.
• Two key ways financial intermediation achieves this:
  • Collecting information to evaluate alternative investment projects through screening and monitoring of firms, and information production.
  • Inducing individuals to invest in illiquid but more productive technologies by providing liquidity and risk sharing.

Financial Development and Saving Rate

• The impact of financial development on the saving rate is ambiguous, with two opposing effects:
  • Negative effect: Higher levels of financial development induce less savings for precautionary reasons.
  • Positive effect: More developed financial systems require less spread, leading to increased savings rate as interest rates on savings get closer to productivity.

Financial Development and Growth

• Establishing a statistical relation between financial development and growth rate: gi = α + βFDi + i
• β coefficient represents the change in growth rate for a 0.1 increase in financial development, with a 2.4% increase in growth rate.
• The sizes of the coefficients are economically large and statistically significant.

Causality in Economics

• Correlations between variables do not necessarily imply causality.
• Causality is important for policy makers to guide policy choices, but it is often difficult to establish.
• King and Levine (1993) showed that finance predicts growth, but did not address the issue of causality.

Financial Accelerator

• The financial accelerator framework suggests that economic disruptions may be generated or amplified by deteriorating credit-market conditions.
• Two necessary conditions:
  • Financial markets are imperfect (information asymmetry between lenders and borrowers).
  • The relationship between borrowers and savers is mediated by financial intermediaries that operate at some cost.

When Banks Matter

• With asymmetric information between lenders and borrowers, the firm can obtain only a collateralized loan.
• The value of a loan cannot exceed the value of assets, leading to an additional cost to the interest rates for an additional unit of credit.
• Shocks to the collateral value or level, shocks to the financial intermediation technology, or a monetary policy shock may all have real impacts on the borrowers' activity.

Financial Accelerator at Work

• The literature has distinguished two main channels of transmission through a financial accelerator mechanism:
  • The balance sheet channel (shocks to qK).
  • The bank lending channel (shocks to m).
• A key assumption for the financial accelerator theory to hold is the presence of financial frictions that prevent the switch from intermediated to direct lending.

Financial Structure and Growth

• Estimate the model: git = α + β1 Sit−1 + β2 Sit−1 xPit−1 + γXit−1 + Fi + Tt + it
• A positive/negative estimated β1 indicates that relatively larger market-based financing countries display higher/lower economic growth in normal times.

Financial Structure and Growth - Results in LP (2016)

• An increase in the bank-market ratio is associated with lower GDP growth in the subsequent five-year period.
• This effect is larger when interacted with housing market crises, but not with stock market crises.

Macroeconomic Consequences of Micro Financial Imperfections

• The Great Financial Crisis suggests that financial markets are not a veil, against the real business cycle view.
• Real business cycle models have been developed mainly disregarding the role of financial intermediation.
• The credit view developed starting from the contributions of Mishkin (1978) and Bernanke (1983).
• Financial intermediaries may have a role for macroeconomic fluctuations or temporary deviations from long-run trend.

Deciphering the 2007-2009 Great Financial Crisis (GFC)

• Macroeconomic considerations:
  • Analyzing the premises to the US financial crisis.
  • The credit view developed starting from the contributions of Mishkin (1978) and Bernanke (1983).