Bank Capital Flows and Asset Prices

Abstract

We embed the notion of intermediaries as risk-reducing monitors into a dynamic general-equilibrium asset pricing framework, and consider an economy in which capital can be moved between an intermediated banking sector and a risky sector. We characterize how resources are optimally allocated between these sectors as a function of the relative size of the banking sector - the bank share - and the maximum speed at which capital can move into and out of that sector - financial flexibility. In equilibrium, the realized capital flow, i.e., the capital mobility, is a nontrivial function of the bank share and is directly related to the risk of systemic crashes. The model has strong asset pricing implications; for example, price-dividend ratios are lower the higher the financial flexibility. The relationship between financial flexibility and real growth rates is ambiguous; high financial flexibility may lead to either higher or lower growth rates. Methodologically, our paper contributes to the two-trees literature by allowing for reallocation of resources between trees in a tractable framework; this flexible-tree approach allows for stationary share distributions as an equilibrium outcome.