Costly Intermediation and Consumption Smoothing

Article excerpt

I. INTRODUCTION

Financial intermediaries play an essential role in economies, transferring funds from agents who do not wish to use them immediately to those who do, improving the allocation of resources with consequences for efficiency and welfare. As Hahn (1971) pointed out, financial intermediation is not a costless activity: It uses real resources, such as labor and capital, and governments often tax such activity. This generates a wedge between the deposit and borrowing rates and consequently implies that households face different interest rates, depending on whether they are savers or borrowers. We construct a neoclassical growth model with costly intermediation, in order to analyze two positive questions: (1) What are the quantitative welfare implications of intermediation costs? (2) Are the welfare effects evenly distributed across individuals with different levels of wealth?

Individuals in our neoclassical growth model face uninsurable idiosyncratic shocks to labor productivity, an endogenous borrowing limit, and costly intermediation. Households smooth consumption over time by making deposits at a financial intermediary in good times and running down credit balances or getting loans in bad times. Intermediation costs generate a wedge between loan and deposit rates, with interest payments on loans higher than the return on deposits. We assume that financial institutions provide all the intermediation, and therefore abstract from direct borrowing and lending between households. (1) As in Martins-da-Rocha and Vailakis (2010), the intermediary has a labor-intensive technology, maximizes profit, is remunerated by the marginal product of labor, and takes regulation as given. (2) See Hahn (1971), Diaz-Gimenez et al. (1992), and Mehra, Piguillem, and Prescott (2011) for similar approaches.

Our goal is to analyze the effects of intermediation costs on agents' intertemporal ability to smooth consumption and insure against labor income shocks. As a consequence, we focus on unsecured consumption loans such as personal loans and credit card debt, and abstract from the effects of intermediation costs on entrepreneurship and productivity. Unsecured consumption loans, while only a subset of the total credit market, allow us to construct a direct measure of intermediation costs for our quantitative exercise. In addition, the fraction of unsecured credit over all credit in the data provides another dimension on which we can assess the performance of our model.

We use our model to measure key statistics of the U.S. economy, including intermediation costs, and perform counterfactual experiments. Reducing intermediation costs leads to two effects. First, for a given interest rate, decreasing borrowing costs expands net borrowers' consumption possibility frontiers and even current savers may benefit (with positive probability they may need to borrow to smooth consumption in the future due to bad labor productivity shocks). Second, there is an indirect effect: lower intermediation costs imply an increase in the demand for loans, which raises the interest rate. This offsets part of the decrease in borrowing costs and also increases interest income, improving savers' welfare. Determining the net impact of these effects requires a quantitative analysis.

We interpret a reduction in intermediation costs as an improvement in the financial intermediation technology or a reduction in taxes on financial transactions. The welfare analysis focuses on stationary equilibria and transitional dynamics. The transition is slow, and abstracting from it can lead to misleading welfare calculations. Also, mobility in wealth means that comparing, for instance, the agent with median wealth in two stationary equilibria may not involve the same household. We find three main quantitative results:

First, intermediation costs have a large effect on welfare. For the U.S. economy, the average aggregate welfare gain of all agents from reducing intermediation costs from 3. …