Financial Flexibility, Bank Capital Flows, and Asset Prices

We develop a parsimonious general-equilibrium model of banking and asset pricing, in which intermediaries have the expertise to monitor and reallocate capital. The model allows us to study the connection between financial development, intra-economy capital flows, the size of the banking sector, the value of intermediation, expected returns in the market, and the risk of bank crashes. We show that realized capital flows are informative about financial development, whereas other common empirical proxies, such as the size of the banking sector, may be only weakly related. Our model also has strong asset-pricing implications; for example, a market’s dividend yield is related to its financial flexibility, and capital flows should be important in explaining expected returns and the risk of bank crashes. The model’s predictions are broadly consistent with the aggregate behavior of the U.S. economy since 1950. ∗A previous draft of this paper was entitled “The Credit Channel and the Term Structure.” We thank Jonathan Berk, Harjoat Bhamra, Zhiwu Chen, Gian Luca Clementi, Bob Goldstein, Dwight Jaffee, Martin Lettau, Hayne Leland, Dmitry Livdan, Svein-Arne Persson, Matt Spiegel, Nancy Wallace, James Wilcox, Amir Yaron, and seminar participants at UBC, the University of Minnesota, Wharton, Yale, the 2009 EFA, and the 2010 North American Winter Meetings of the Econometric Society for helpful comments. We are also grateful to the Editor, an Associate Editor, and two referees for valuable suggestions. †Haas School of Business, U.C. Berkeley, 545 Student Services Building #1900, Berkeley, CA 94720-1900, phone: 510-643-9391, fax: 510-643-1412, e-mail: parlour@haas.berkeley.edu. ‡Haas School of Business, U.C. Berkeley, 545 Student Services Building #1900, Berkeley, CA 94720-1900, phone: 510-642-7382, fax: 510-643-1412, e-mail: stanton@haas.berkeley.edu. §Haas School of Business, U.C. Berkeley, 545 Student Services Building #1900, Berkeley, CA 94720-1900, phone: 510-643-0547, fax: 510-643-1412, e-mail: walden@haas.berkeley.edu. Why is a well-developed financial sector important and what effect does it have on the risk in an economy? According to the development literature, financial development leads to economic growth because it allows intermediaries to carry out tasks such as reducing investment costs or pooling capital more efficiently.1 However, in this view of financial development there is no channel for intermediaries either to avert or to create systemic risk. By contrast, in the banking literature, the fundamental role of intermediaries is to transform risk. Specifically, intermediaries have the expertise to reallocate investment capital, and so they provide a link between capital owners and entrepreneurs, allowing both to achieve the optimal mix of risk and returns. Intermediaries also have the expertise to change the risk of existing investments by monitoring. From the perspective of this literature, financial development is identified with financial flexibility—the efficiency with which capital can be reallocated and monitored. In the wake of the recent financial crisis, understanding the economy-wide impact of this transformation role of intermediaries on risk, capital allocation, and asset prices is crucial. In this paper, we focus on these two special properties of the financial sector—financial flexibility and risk transformation—and show in a parsimonious dynamic general-equilibrium model how they lead to a rich set of implications that are broadly consistent with observed market behavior. Specifically, there is a direct connection between the degree of financial flexibility in an economy, the size of the banking sector, the value of intermediation, expected returns in the market, real growth rates, intra-economy capital flows (including “flight-to-quality”), and the risk of bank crashes. In our framework, the economy has an optimal level of intermediated capital, which depends on technological processes and on any financial frictions that prevent instantaneous adjustment. In competitive equilibrium, intermediaries cause capital to flow to bring the economy towards this optimal fraction. There is therefore a close relation between time-varying real and financial variables, on the one hand, and the size, flow and value of intermediated capital, on the other. Our paper makes two main contributions by relating unobservable financial flexibility to capital flows and asset prices. First, our theory shows that realized capital flows are informative about financial development, whereas other common empirical proxies, such as the size of the intermediated sector, may be only weakly related. The model’s predictions about capital flows are consistent with what is observed in practice. It is, for example, natural to observe a “flight-to-quality,” i.e., extended periods of high demand for low-risk assets, after market crashes originating in the intermediated sector. Second, the model has strong asset-pricing implications. For example, a market’s dividend yield is related to its financial flexibility, and capital flows should be important in explaining expected returns and the risk of bank crashes. The dividend-yield result suggests that cross-country differences in price-dividend ratios can be explained by financial flexibility and by how far the economy is from its optimal capital mix. Also, at the sector level, financial variables will to a large extent be determined by which firms capture the value of risk transformation that intermediation provides. We show that the value of intermediation can indeed be substantial. We also show that the model is broadly consistent with the aggregate behavior of the U.S. Levine (2005) surveys the empirical and theoretical development literatures.