Financial Markets, Intermediaries, and Intertemporal Smoothing

95-4

Posted: 5 Apr 1995

See all articles by Franklin Allen

Franklin Allen

Imperial College London

Douglas M. Gale

New York University (NYU) - Department of Economics

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Abstract

The returns of assets that are traded on financial markets are more volatile than the returns offered by intermediaries such as banks and insurance companies. This suggests that individual investors are exposed to more risk in countries which rely heavily on financial markets. In the absence of a complete set of Arrow-Debreu securities, there may be a role for institutions that can smooth asset returns over time. In this paper, we consider one such mechanism. We present an example of an economy in which the incompleteness of financial markets leads to underinvestment in reserves whereas the optimum, for a broad class of welfare functions, requires the holding of large reserves in order to smooth asset returns over time. We then argue that a long-lived intermediary may be able to implement the optimum. However, the position of the intermediary is fragile; competition from financial markets can cause the intertemporal smoothing mechanism to unravel, in which case the intermediary will do no better than the market. The views expressed here are those of the authors and do not necessarily represent the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.

JEL Classification: G12, G29

Suggested Citation

Allen, Franklin and Gale, Douglas M., Financial Markets, Intermediaries, and Intertemporal Smoothing. 95-4. Available at SSRN: https://ssrn.com/abstract=6890

Franklin Allen (Contact Author)

Imperial College London ( email )

South Kensington Campus
Exhibition Road
London, Greater London SW7 2AZ
United Kingdom

Douglas M. Gale

New York University (NYU) - Department of Economics ( email )

269 Mercer Street, 7th Floor
New York, NY 10011
United States
(212) 998-8944 (Phone)
(212) 995-3932 (Fax)

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