Cost Of Financial Intermediation Research Articles

Search-Based Endogenous Illiquidity and the Macroeconomy

We endogenize asset liquidity in a dynamic general equilibrium model with search frictions on asset markets. In the model, asset liquidity is tantamount to the ease of issuance and resaleability of private financial claims, which is driven by investors' participation on the search market. Limited market liquidity of private claims creates a role for liquid assets, such as government bonds or fiat money, to ease financing constraints. We show that endogenising liquidity is essential to generate positive comovement between asset (re)saleability and asset prices. When the capacity of the asset market to channel funds to entrepreneurs deteriorates, investment falls while the hedging value of liquid assets increases, driving up liquidity premia. Our model, thus, demonstrates that shocks to the cost of financial intermediation can be an important source of fight-to-liquidity dynamics and macroeconomic fluctuations, matching key business cycle characteristics of the U.S. economy.

Access to Credit and the Size of the Formal Sector in Brazil

This paper studies the link between credit conditions and formalization in Brazil, as both credit and the rate of formalization have notably increased in the last decade. A firm dynamics model with endogenous formal and informal sectors is developed to quanti- tatively evaluate how much of the change in corporate credit and the size of the formal sector can be attributed to a reduction in the cost of financial intermediation. The model predicts that the observed reduction in intermediation costs generates an increase in the credit-to-output ratio and in the share of formal workers, in line with the data. It is found that-by affecting the corporate interest rate, the allocation of capital and the entry and exit rates-the change in credit conditions has important effects on firm size distribution and aggregate productivity.

Taking Asymmetric Information Seriously: How the London Stock Exchange Protected Price Formation

This paper studies the problem of asymmetric information that exists in financial markets between the public and the market makers, that is, the securities dealers who support the stability of asset prices by carrying inventory over short periods of time. Market makers in modern markets typically have access to information about a broad range of markets and trade on the basis of this information. While trade on fundamental information about the value of assets is necessary for asset prices to be informative, trade on market information, such as the presence in the market of a highly motivated seller, often does not make prices more informative. Modern regulation in the U.S. has generally taken a permissive approach both to trading on market information, and also to the proliferation of conflicts of interest that increase profit opportunities from trading on market information. This paper critiques this regulatory approach by explaining that economic theory does not in general indicate that there are efficiency gains from permitting trading on market information, by describing an alternate model of a financial market, the pre-1986 London Stock Exchange which required dealers to avoid conflicts of interest and limited trading on market information by not making public the size of trades, and by discussing recent scandals that illustrate the costs of trading on market information.The costs and benefits of trading on market information are very difficult to measure because of the absence of benchmark prices against which the prices that are observed in markets can be compared. One proxy for measuring the net costs of such trading is the aggregate cost of financial intermediation: if this falls during a time period when conflicts of interest and opportunities to trade on market information have increased, then one might conclude that the consequences of trading on such information are unlikely to be large. In fact, over the relevant time period there was a dramatic increase in the costs of financial intermediation. While recognizing that the evidence offered here of social cost created by trading on market information is far from conclusive, this paper proposes two policies that could mitigate such costs: a requirement that market makers avoid conflicts of interest, and the non-release of some intraday market data to reduce the market information on which trade can take place.

Financial Stability Monitoring

We present a forward-looking monitoring program to identify and track the sources of systemic risk over time and to facilitate the development of preemptive policies to promote financial stability. We offer a framework that distinguishes between shocks, which are difficult to prevent, and vulnerabilities, which amplify shocks. Building on substantial research, we focus on leverage, maturity transformation, interconnectedness, complexity, and the pricing of risk as the primary vulnerabilities in the financial system. The monitoring program tracks these vulnerabilities in four areas: the banking sector, shadow banking, asset markets, and the nonfinancial sector. The framework also highlights the policy trade-off between reducing systemic risk and raising the cost of financial intermediation by taking preemptive actions to reduce vulnerabilities.

An International Look at the Growth of Modern Finance

We study the rise of finance across a set of now-industrial economies. The long-run pattern of the growth of the income share of finance from the nineteenth century to current times in the United States is similar to some economies, but not all economies reach the same size and instead reach a plateau. The relationship between financial output and income is nonhomothetic and changes three times in this sample. Most of the increase in real GDP per capita from 1870 occurred while financial output and the income share of finance were smaller than their size in 1980. After 1980 the elasticity of income with respect to financial output falls significantly. We find considerable heterogeneity in the size of finance in recent times. There is no evidence for an increase in the unit cost of financial intermediation. We find that information technology and financial deregulation can help explain the increase in relative skill intensity and in relative wages in finance, while common trends, which may be related to financial globalization, also play a role.

Financial Stability Monitoring

While the Dodd Frank Act (DFA) broadens the regulatory reach to reduce systemic risks to the U.S. financial system, it does not address some important risks that could migrate to or emanate from entities outside the federal safety net. At the same time, it limits the types of interventions by financial authorities to address systemic events when they occur. As a result, a broad and forward-looking monitoring program, which seeks to identify financial vulnerabilities and guide the development of pre-emptive policies to help mitigate them, is essential. Systemic vulnerabilities arise from market failures that can lead to excessive leverage, maturity transformation, interconnectedness, and complexity. These vulnerabilities, when hit by adverse shocks, can lead to fire sale dynamics, negative feedback loops, and inefficient contractions in the supply of credit. We present a framework that centers on the vulnerabilities that propagate adverse shocks, rather than shocks themselves, which are difficult to predict. Vulnerabilities can emerge in four areas: (1) systemically important financial institutions (SIFIs), (2) shadow banking, (3) asset markets, and (4) the nonfinancial sector. This framework also highlights how policies that reduce the likelihood of systemic crises may do so only by raising the cost of financial intermediation in non-crisis periods.

Financial Globalization and Monetary Transmission

This paper analyzes the way in which international financial integration affects the transmission of monetary policy in a New Keynesian open economy framework. It extends Woodford’s (2010) analysis to a model with a richer financial markets structure, allowing for international trading in multiple assets and subject to financial intermediation costs. Two different forms of financial integration are considered, in particular an increase in the level of gross foreign asset holdings and a decrease in the costs of international asset trading. The simulations in the calibrated model show that none of the analyzed forms of financial integration undermine the effectiveness of monetary policy in influencing domestic output and inflation. Under realistic parameterizations, monetary policy is more, rather than less, effective as the positive impact of strengthened exchange rate and wealth channels more than offsets the negative impact of weakened interest rate channels. The paper also analyzes the interaction of financial integration with trade integration, varying both the importance of trade linkages and the degree of exchange rate pass-through. These interactions show that the positive effects of financial integration are amplified by trade integration. Overall, monetary policy is most effective in parameterizations with the highest degree of both financial and real integration.

Financial intermediation costs in low income countries: The role of regulatory, institutional, and macroeconomic factors

We analyze factors driving persistently higher financial intermediation costs in low-income countries (LICs) relative to emerging market (EM) country comparators. Using the net interest margin as a proxy for financial intermediation costs at the bank level, we find that within LICs a substantial part of the variation in interest margins can be explained by bank-specific factors: margins tend to increase with higher riskiness of credit portfolio, lower bank capitalization (or lower risk aversion), and smaller bank size. Overall, we find that concentrated market structures and lack of competition in LICs banking systems and institutional weaknesses constitute the key impediments preventing financial intermediation costs from declining. Our results provide strong evidence that policies aimed at fostering banking competition and strengthening institutional frameworks can reduce intermediation costs in LICs.

DO INVESTMENT‐SPECIFIC TECHNOLOGICAL CHANGES MATTER FOR BUSINESS FLUCTUATIONS? EVIDENCE FROM JAPAN

AbstractThe observed decline in the relative price of investment goods to consumption goods in Japan suggests the existence of investment‐specific technological (IST) changes. We examine whether IST changes are a major source of business fluctuations in Japan, by estimating a dynamic stochastic general equilibrium model using Bayesian methods. We show that IST changes are less important than neutral technological changes in explaining output fluctuations. We also demonstrate that investment fluctuations are mainly driven by shocks to investment adjustment costs. Such shocks represent variations of costs involved in changing investment spending, such as financial intermediation costs. We find that the estimated series of the investment adjustment cost shock correlates strongly with the diffusion index of firms' financial position in theTankan(Short‐term Economic Survey of Enterprises in Japan). Therefore, we argue that the large decline in investment growth in the early 1990s was due to an increase in investment adjustment costs stemming from firms' financial constraints after the collapse of Japan's asset price bubble.

Why is the Cost of Financial Intermediation Rising in Botswana?

The Botswana banking system has witnessed substantial deregulation in the past three decades with the entry of foreign banks, mergers and acquisitions in the banking system and policy aimed at deregulating interest rates by moving towards more market determined interest rates. These measures should increase competition and reduce inefficiency in the banking system both resulting in lower costs of financial intermediation. However, the cost of financial intermediation has not only remained high but is also rising. This work uses data from the three largest banks from Botswana to investigate the impact of bank specific, industry specific and macroeconomic factors in determining the cost of financial intermediation. Our results show that balance sheet factors, industry specific and macroeconomic variables account for wide bank spreads and hence the high cost of financial intermediation in Botswana. The paper concludes by suggesting that better focused regulatory oversights by the central bank, a reform plan that will boost the supervision of the panoply of non-bank financial institutions and a further strengthening of the fiscal and exchange rate to ensure sustainable macroeconomic position will help to contain the rising cost of financial intermediation.

Financial Intermediation Costs in Low-Income Countries: The Role of Regulatory, Institutional, and Macroeconomic Factors

We analyze factors driving persistently higher financial intermediation costs in low-income countries (LICs) relative to emerging market (EMs) country comparators. Using the net interest margin as a proxy for financial intermediation costs at the bank level, we find that within LICs a substantial part of the variation in interest margins can be explained by bank-specific factors: margins tend to increase with higher riskiness of credit portfolio, lower bank capitalization, and smaller bank size. Overall, we find that concentrated market structures and lack of competition in LICs banking systems and institutional weaknesses constitute the key impediments preventing financial intermediation costs from declining. Our results provide strong evidence that policies aimed at fostering banking competition and strengthening institutional frameworks can reduce intermediation costs in LICs.

Financial Intermediation Costs in Low-Income Countries: The Role of Regulatory, Institutional, and Macroeconomic Factors

We analyze factors driving persistently higher financial intermediation costs in low-income countries (LICs) relative to emerging market (EMs) country comparators. Using the net interest margin as a proxy for financial intermediation costs at the bank level, we find that within LICs a substantial part of the variation in interest margins can be explained by bank-specific factors: margins tend to increase with higher riskiness of credit portfolio, lower bank capitalization, and smaller bank size. Overall, we find that concentrated market structures and lack of competition in LICs banking systems and institutional weaknesses constitute the key impediments preventing financial intermediation costs from declining. Our results provide strong evidence that policies aimed at fostering banking competition and strengthening institutional frameworks can reduce intermediation costs in LICs.

Serbia: Policies to enhance competitiveness

The main purpose of the paper is to discuss an apparent erosion of competitiveness of the Serbian economy in the aftermath of the global crisis and to propose a set of policy interventions that would restore the pre-crisis level of competitiveness, as well as support the resumption of institutional and policy reforms needed to close the gap with new EU members and other candidate countries. Comprehensive measures of competitiveness (such as GCI produced by the World Economic Forum), empirical studies, and academic papers provide a wealth of information on key determinants of competitiveness, growth, and current account sustainability. GCI alone measures 111 indicators organized into 12 pillars and three blocks focusing on basic requirements, efficiency and innovation. Empirical studies identified dozens of factors that contribute to or explain import and export dynamics, and determine CA movements with large numbers of possible policy combinations (mixes) that could be associated with desirable growth outcomes. Clearly, not all factors are equally important or really binding. To identify the key binding constraints to competitiveness and sustainable growth of the Serbian economy the paper uses a diagnostic methodology advanced by Rodrik and Hausmann [9] and further developed by Hausmann et al. [1 ]. We confirm recent empirical findings and claims of Serbian businesses that the real effective exchange rate (REER) indeed represents an immediate binding constraint on competitiveness and growth which needs to be addressed as soon as possible. However, it should be stressed that finding and maintaining equilibrium REER is not a panacea that will cure all problems of tradable sector in Serbia. It is closely followed by high real cost of financing and inefficient financial intermediation, expensive and intrusive state (resulting in costly uncompetitive business environment), and inefficient management and labor force (manifested through high unit labor costs or low productivity). These constraints need to be addressed in short sequence to restart the engines of export led growth.

Economic Freedom and Bank Intermediation Spreads: Do Countries Level of Economic Development Make a Difference?

The impact of economic freedom on the well being of the economy has been widely documented in the literature. Noticeably absent is empirical evidence on the influence of economic freedom on cost of financial intermediation. This limitation is somewhat surprising given the fact that the banking sector remains the most important channel for savings and allocations of credit. By using data on the ASEAN-5 banking sectors, the paper attempts to fill in this demanding gap. The results indicate that restrictions on the activities of which banks could undertake reduces their margins. We also find evidence supporting for government interventions contention. However, the impacts of the different dimensions of economic freedom are not uniform across countries with different levels of income.

Market Segmentation and the Cost of Capital in a Domestic Market: Evidence from Municipal Bonds

We study the implications of market segmentation in a domestic setting, the US municipal bond market. A (state‐level) segmentation of this market emerges from asymmetric tax exemption. Municipal bond investors are exempt from state and local taxes on bonds issued by their own state, but not on bonds issued by other states. We demonstrate that market segmentation imposes significant costs on both issuers and investors in the form of higher yields and higher costs of financial intermediation. Our results provide insight into some well‐documented artifacts of the municipal bond market, such as high yields and the popularity of insurance.

Slow-Moving Traps

This paper studies the link between productivity and technological change in both the real and financial sectors and its effect on growth. The financial system affects technological change in the real sector by providing the funds that firms in the real sector need to implement more advanced technologies. In turn, the widespread use of advanced technologies in the real sector facilitates technological innovation in the financial sector, reducing financial intermediation costs. Thus, technological change in both sectors is mutually reinforcing and may generate multiple balanced growth paths with different financial intermediation costs, interest spreads and technological gaps.

FINANCIAL INTERMEDIATION, LIQUIDITY, AND INFLATION

This paper develops a search-theoretic model to study the interaction between banking and monetary policy and how this interaction affects allocation and welfare. Regarding how banking affects the welfare costs of inflation, we find that, with banking, inflation generates lower welfare costs. We also find that lowering inflation improves welfare not just by reducing consumption/production distortions, but also by avoiding financial intermediation costs. Therefore, understanding the nature of financial intermediation is critical for accurately assessing the welfare gain from lowering the inflation rate. Regarding how monetary policy affects the welfare effects of banking, we find that, when the inflation is low, banking is not active in channeling liquidity; when inflation is high, banking is active and improves welfare; and when inflation is moderate, banking is active but reduces welfare. Owing to general-equilibrium feedback, banking is supported in equilibrium even though welfare is higher without banking.

On the determinants of interest margin in transition banking: the case of Serbia

PurposeThe purpose of this paper is to study the link between, on one hand the interest margin of the bank, and the determinants of the interest margin on the other. The basic importance of bank interest margin or spread (BIS), arises from the fact that it presents an indicator of a bank's profitability as well as the cost of financial intermediation imposed on both its depositors and debtors.Design/methodology/approachTo test the relationship using multiple linear regressions with lagged variables (OLS – ordinary least squares). In addition using correlation analysis as well as bootstrapping model was necessary to overcome the issue of unknown statistical distribution of small data samples.FindingsThe quantitative study reveals proposed positive and significant correlation between bank interest margins and proxies of interest‐rate risk, negative correlation with risk averseness, positive but slightly lower correlation with credit risk variable, and finally, not so strong influence of foreign bank entry. Research limitations/implications –To be more reliable, models should include individual bank‐specific data for cross‐banks examination, an area worthy of further research.Social implicationsHaving implemented the methodology, the paper draws some policy recommendations. To make interest margin optimal, authorities should redesign existing system of deposit protection together with building institutional credit guarantees and thus enable relevant information to flow freely amongst participants, i.e. to establish official information sharing arrangements for bank industry.Originality/valueThis is the first econometric study of the bank interest spread determinants for the Serbian banking industry.

Re-examining the impact of foreign bank participation on interest margins in emerging markets

Over the past two decades, emerging markets have witnessed a considerable increase in foreign bank participation, with the anticipation that foreign entry would lower financial intermediation costs. We re-examine the impact of foreign participation on bank interest margins using data on 11 Central and Eastern European countries (CEECs), where the increase in foreign bank participation was the strongest. Using the modified dealership model of Maudos and Fernandez de Guevara (2004) as a baseline specification, we show that augmenting the model by proxies for direct and indirect impact of foreign bank participation does not produce a significant outcome. We explain our results by the fact that the dealership model fully accounts for the mechanisms through which foreign bank presence is hypothesized to affect interest margins in theoretical models on international banking. We call for re-examination of some of the previous findings showing a significant own effect of foreign bank participation on interest margins in emerging markets within the framework of the dealership model.

Bank mergers, branch networks and economic growth: Theory and evidence from Canada, 1889–1926

This paper incorporates a monopolistically competitive market for deposits a la’ Salop (1979) into an overlapping generations growth model a la’ Diamond (1965). Profit-maximizing banks have incentives to compete for deposits by opening branches or expanding branch networks through mergers and acquisitions. Larger branch networks reduce the transaction cost of financial intermediation and encourage depositors to save more, hence resulting in higher per capita output. Empirically, the development of the Canadian banking industry during 1889–1926, notably the merger wave in the early 1900s, is examined. A VECM shows that savings, real GNP and the number of bank branches, all on a per capita basis, are cointegrated – with long-run savings being a positive function of the other two variables. Results of innovation accounting are also consistent with predictions of the theory. Our findings not only have policy implications for bank branch deregulation as well as mergers and acquisitions but also shed light on the debate about the finance-growth nexus in Canada.