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Financial markets, intermediaries, and intertemporal smoothing

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  • Franklin Allen
  • Douglas Gale

Abstract

The return 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 overlapping generations economy in which the incompleteness of financial markets leads to underinvestment in reserves. There exist allocations where by building up large reserves it is possible to smooth asset returns and eliminate non-diversifiable risk. This allows an ex ante Pareto improvement. We then argue that a long-lived intermediary may be able to implement this type of smoothing. 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.

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Bibliographic Info

Paper provided by Federal Reserve Bank of Philadelphia in its series Working Papers with number 95-4.

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Date of creation: 1995
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Handle: RePEc:fip:fedpwp:95-4

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Related research

Keywords: Financial markets ; Investments;

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References

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  1. Franklin Allen & Douglas Gale, 1994. "A welfare comparison of intermediaries and financial markets in Germany and the U.S," Working Papers, Federal Reserve Bank of Philadelphia 95-3, Federal Reserve Bank of Philadelphia.
  2. Fulghieri, P. & Rovelli, R., 1993. "Capital Markets, Financial Intermediaries, and the Supply of Liquidity in a Dynamic Economy," Papers, Columbia - Graduate School of Business 93-04, Columbia - Graduate School of Business.
  3. Roger H. Gordon & Hal R. Varian, 1985. "Intergenerational Risk Sharing," NBER Working Papers 1730, National Bureau of Economic Research, Inc.
  4. Bhattacharya, S. & Padilla, A. Jorge, 1994. "Dynamic Banking : A Reconsideration," Discussion Papers (IRES - Institut de Recherches Economiques et Sociales), Université catholique de Louvain, Institut de Recherches Economiques et Sociales (IRES) 1994031, Université catholique de Louvain, Institut de Recherches Economiques et Sociales (IRES).
  5. Allen, Franklin & Gale, Douglas, 1994. "Limited Market Participation and Volatility of Asset Prices," American Economic Review, American Economic Association, American Economic Association, vol. 84(4), pages 933-55, September.
  6. Qi, Jianping, 1994. "Bank Liquidity and Stability in an Overlapping Generations Model," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 7(2), pages 389-417.
  7. Joseph G. Altonji & Fumio Hayashi & Laurence J. Kotlikoff, 1989. "Is the Extended Family Altruistically Linked? Direct Tests Using Micro Data," NBER Working Papers 3046, National Bureau of Economic Research, Inc.
  8. Melitz, Jacques, 1990. "Financial deregulation in France," European Economic Review, Elsevier, Elsevier, vol. 34(2-3), pages 394-402, May.
  9. Hayashi, Fumio & Altonji, Joseph & Kotlikoff, Laurence, 1996. "Risk-Sharing between and within Families," Econometrica, Econometric Society, Econometric Society, vol. 64(2), pages 261-94, March.
  10. Bennett T. McCallum, 1988. "The Optimal Inflation Rate in an Overlapping-Generations Economy with Land," NBER Working Papers 1892, National Bureau of Economic Research, Inc.
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