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Incomplete insurance, irreversible investment, and the microfoundations of financial intermediation

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  • Robert A. Johnson
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    Abstract

    The financial intermediary is shown to result from a market imperfection related to the costly monitoring of the actions of consumers. In such an environment complete insurance is not obtainable and consumers respond by holding some of their wealth as precautionary balances in order to self-insure. Precautionary balances are those financial vehicles which permit one to invest and then liquidate with the smallest amount of loss because of the "sunk costs" associated with the transaction. An economy of N identical consumers is created and it is shown that a financial intermediary which collects the precautionary balances of the community can then implement risk sharing and liberate social resources for greater investment.

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    File URL: http://www.federalreserve.gov/pubs/ifdp/1986/289/default.htm
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    File URL: http://www.federalreserve.gov/pubs/ifdp/1986/289/ifdp289.pdf
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    Bibliographic Info

    Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series International Finance Discussion Papers with number 289.

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    Date of creation: 1986
    Date of revision:
    Handle: RePEc:fip:fedgif:289

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    Related research

    Keywords: Saving and investment ; Consumer behavior ; Insurance;

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    1. Benston, George J & Smith, Clifford W, Jr, 1976. "A Transactions Cost Approach to the Theory of Financial Intermediation," Journal of Finance, American Finance Association, vol. 31(2), pages 215-31, May.
    2. Ben S. Bernanke, 1980. "Irreversibility, Uncertainty, and Cyclical Investment," NBER Working Papers 0502, National Bureau of Economic Research, Inc.
    3. Ratti, Ronald A., 1979. "Stochastic reserve losses and bank credit expansion," Journal of Monetary Economics, Elsevier, vol. 5(2), pages 283-294, April.
    4. Diamond, Douglas W & Dybvig, Philip H, 1983. "Bank Runs, Deposit Insurance, and Liquidity," Journal of Political Economy, University of Chicago Press, vol. 91(3), pages 401-19, June.
    5. Baltensperger, Ernst, 1972. "Economies of Scale, Firm Size, and Concentration in Banking," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 4(3), pages 467-88, August.
    6. Baltensperger, Ernst, 1980. "Alternative approaches to the theory of the banking firm," Journal of Monetary Economics, Elsevier, vol. 6(1), pages 1-37, January.
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