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Is There an Optimal Size for the Financial Sector

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  • Anthony M. Santomero
  • John J. Seater

Abstract

This paper derives the optimal size of the financial sector using a general equilibrium framework that is an extension of Holmstrom and Tirole's 1997 paper. We show that the financial sector has a unique optimal size relative to the size of the economy as a whole. Creating and maintaining this sector requires diversion of some physical capital from production of output to monitoring that production. However, the efficiency gain in output production brought about by monitoring warrants the diversion. It is also found that the optimal size of the financial sector is independent of the state of the economy and does not vary over the business cycle.

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File URL: http://fic.wharton.upenn.edu/fic/papers/98/9835.pdf
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Bibliographic Info

Paper provided by Wharton School Center for Financial Institutions, University of Pennsylvania in its series Center for Financial Institutions Working Papers with number 98-35.

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Date of creation: Feb 1999
Date of revision:
Handle: RePEc:wop:pennin:98-35

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Keywords: financial sector; intermediation theory; financial institutions;

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References

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  1. Ben Bernanke & Mark Gertler, 1987. "Financial Fragility and Economic Performance," NBER Working Papers 2318, National Bureau of Economic Research, Inc.
  2. Holmström, Bengt & Tirole, Jean, 1994. "Financial Intermediation, Loanable Funds and the Real Sector," IDEI Working Papers 40, Institut d'Économie Industrielle (IDEI), Toulouse.
  3. Tobin, James, 1969. "A General Equilibrium Approach to Monetary Theory," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 1(1), pages 15-29, February.
  4. Bhattacharya Sudipto & Thakor Anjan V., 1993. "Contemporary Banking Theory," Journal of Financial Intermediation, Elsevier, vol. 3(1), pages 2-50, October.
  5. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, vol. 51(3), pages 393-414, July.
  6. Hayne E. Leland and David H. Pyle., 1976. "Informational Asymmetries, Financial Structure, and Financial Intermediation," Research Program in Finance Working Papers 41, University of California at Berkeley.
  7. Franklin Allen, Douglas Gale, 1988. "Optimal Security Design," Review of Financial Studies, Society for Financial Studies, vol. 1(3), pages 229-263.
  8. Allen, Franklin & Santomero, Anthony M., 1997. "The theory of financial intermediation," Journal of Banking & Finance, Elsevier, vol. 21(11-12), pages 1461-1485, December.
  9. Bernanke, Ben & Gertler, Mark, 1989. "Agency Costs, Net Worth, and Business Fluctuations," American Economic Review, American Economic Association, vol. 79(1), pages 14-31, March.
  10. Fama, Eugene F., 1985. "What's different about banks?," Journal of Monetary Economics, Elsevier, vol. 15(1), pages 29-39, January.
  11. Bernanke, Ben S, 1981. "Bankruptcy, Liquidity, and Recession," American Economic Review, American Economic Association, vol. 71(2), pages 155-59, May.
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Citations

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Cited by:
  1. Gianni De Nicoló & Sami Geadah & Dmitriy Rozhkov, 2003. "Financial Development in the CIS-7 Countries: Bridging the Great Divide," IMF Working Papers 03/205, International Monetary Fund.
  2. Lin Lin & Hsien-Chang Kuo & I-Liang Lin, 2008. "Merger and optimal number of firms: an integrated simulation approach," Applied Economics, Taylor & Francis Journals, vol. 40(18), pages 2413-2421.
  3. Drew Saunders, 2009. "The Elastic Provision of Liquidity by Private Agents," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 41(7), pages 1423-1451, October.
  4. John J. Seater, 2000. "Optimal Bank Regulation and Monetary Policy," Center for Financial Institutions Working Papers 00-38, Wharton School Center for Financial Institutions, University of Pennsylvania.
  5. Miyake, Atsushi & Nakamura, Tamotsu, 2007. "A dynamic analysis of an economy with banking optimization and capital adequacy regulations," Journal of Economics and Business, Elsevier, vol. 59(1), pages 14-27.
  6. Michael Graff, 2005. "Is There an Optimum Level of Financial Activity?," KOF Working papers 05-106, KOF Swiss Economic Institute, ETH Zurich.

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