Risk Pooling, Intermediation Efficiency, and the Business Cycle

Abstract

We study the relationship between intermediation efficiency and the macroeconomic dynamics within a tractable real business cycle model with financial frictions. Households finance firms but, due to restricted equity market participation, cannot pool their idiosyncratic risks. Financial intermediaries provide costly risk pooling by issuing safe assets via balance sheet leverage. We characterize the general equilibrium effects that associate intermediation costs to the output dynamics and show that a more (less) efficient financial sector leads to higher (lower) growth, but also amplifies (dampens) output fluctuations. Relatedly, we identify the mechanisms by which the financial sector’s impact on growth and its safe assets provision generate pro- or counter-cyclical real risk-free rates.

Keywords: Amplification, business cycle, Efficiency, dampening, restricted market participation, risk pooling