Financial Engineering and Economic Development

The vast literature on financial development focuses mostly on the causal impact of the quantity of financial intermediation on economic development and productivity. This paper, instead, focuses on the role of the financial sector in creating securities that cater to the needs of heterogeneous investors. We describe a dynamic extension of Allen and Gale (1989)?s optimal security design model in which producers can tranche the stochastic cash flows they generate at a cost. Lowering security creation costs in that environment leads to more financial investment, but it has ambiguous effects on capital formation, output, and aggregate productivity. Much of the investment boom caused by increased securitization activities can, in fact, be spent on securitization costs and intermediation rents, with little or even negative effects on development and productivity.