Financial Intermediaries, Markets, and Growth

By Falko Fecht, Kevin Huang, and Antoine Martin
Revised: May 2004
(First Version: April 2004)
RWP 04-02
Research Division 
Federal Reserve Bank of Kansas City 

Abstract

      In many models of financial intermediation, markets reduce welfare because they limit the amount of risk-sharing intermediaries can offer.  In this paper we study a model in which markets also promote investment in a productive technology.  A trade-off between risk sharing and growth arises endogenously.  In the model, financial intermediaries provide insurance to households against a liquidity shock.  Households can also invest directly on a financial market if they pay a cost.  In equilibrium, the ability of intermediaries to share risk is constrained by the market.  This can be beneficial because intermediaries invest less in the productive technology when they provide more risk-sharing.  We show the mix of intermediaries and market that maximizes welfare depend on parameter values.  We also show the optimal mix of two very similar economies can be very different. 

Keywords: Financial intermediaries; Financial Markets; Risk-sharing; Growth

JEL Codes: E44; G10; G20

Falko Fecht is an economist at the Economic Research Centre of the Deutsche Bundesbank. Kevin Huang is a senior economist and Antoine Martin is an economist at the Federal Reserve Bank of Kansas City. The authors would like to thank Jerry Hanweck, Frederick Joutz, Todd Keister, as well as seminar participants at the New York Fed, the Missouri Economic Conference 2004, and the WAFA/FDIC 2004 meeting for useful comments. All remaining errors are their own.  The views expressed herein are those of the authors and do not necessarily reflect the views of the Deutsche Bundesbank, the Federal Reserve Bank of Kansas City or the Federal Reserve System.

Fecht email:  Falko.Fecht@bundesbank.de
Huang e-mail:  Kevin.Huang@kc.frb.org
Martin e-mail:  antoine.martin@kc.frb.org

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