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Financial Markets, Intermediaries and Intertemporal Smoothing

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Author Info
Franklin Allen
Douglas Gale

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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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Paper provided by Wharton School Center for Financial Institutions, University of Pennsylvania in its series Center for Financial Institutions Working Papers with number 96-33.

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Date of creation: Sep 1996
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Handle: RePEc:wop:pennin:96-33

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Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
  1. Roger H. Gordon & Hal R. Varian, 1985. "Intergenerational Risk Sharing," NBER Working Papers 1730, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  2. Bhattacharya, Sudipto & Padilla, A Jorge, 1996. "Dynamic Banking: A Reconsideration," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 9(3), pages 1003-32. [Downloadable!] (restricted)
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  3. Allen, Franklin & Gale, Douglas, 1994. "Limited Market Participation and Volatility of Asset Prices," American Economic Review, American Economic Association, vol. 84(4), pages 933-55, September. [Downloadable!] (restricted)
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  4. Hayashi, Fumio & Altonji, Joseph & Kotlikoff, Laurence, 1996. "Risk-Sharing between and within Families," Econometrica, Econometric Society, vol. 64(2), pages 261-94, March. [Downloadable!] (restricted)
  5. Qi, Jianping, 1994. "Bank Liquidity and Stability in an Overlapping Generations Model," Review of Financial Studies, Oxford University Press for Society for Financial Studies, vol. 7(2), pages 389-417. [Downloadable!] (restricted)
  6. 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. [Downloadable!] (restricted)
  7. Melitz, Jacques, 1990. "Financial deregulation in France," European Economic Review, Elsevier, vol. 34(2-3), pages 394-402, May. [Downloadable!] (restricted)
  8. Franklin Allen & Douglas Gale, 1994. "A welfare comparison of intermediaries and financial markets in Germany and the U.S," Working Papers 95-3, Federal Reserve Bank of Philadelphia.
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  9. Fulghieri, P. & Rovelli, R., 1993. "Capital Markets, Financial Intermediaries, and the Supply of Liquidity in a Dynamic Economy," Papers 93-04, Columbia - Graduate School of Business.
  10. Altonji, Joseph G & Hayashi, Fumio & Kotlikoff, Laurence J, 1992. "Is the Extended Family Altruistically Linked? Direct Tests Using Micro Data," American Economic Review, American Economic Association, vol. 82(5), pages 1177-98, December. [Downloadable!] (restricted)
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