The advent of the Euro is the latest phase in the financial integration that is sweeping across Europe. Earlier events of special significance were the promulgation of the Second Banking Coordinating Directive, allowing banks to branch across national boundaries, and the establishment of the Financial Services Policy Group, designed to study inter-country issues arising from financial integration. It is clear that a unified continental financial services market is emerging in Europe. As that market develops, important questions will arise concerning the kind of market structure that will emerge, its appropriate size, and its organization. In many ways, both the developments and questions concerning them parallel those that have arisen in the United States over the last two decades with the increasing degree of financial integration taking place there. In both Europe and the United States, there are related questions concerning the public policies that should be enacted to guarantee that the resulting financial services industry is socially optimal - policies concerning mergers, types of services that can be offered by various types of institutions, capital adequacy requirements, and so on.
In this paper, we address a theoretical question that is important both for the positive and normative analysis of the financial industry, namely, what is the optimal size of that industry? This seems an obvious question for policy analysis, which concerns intervention in the financial industry precisely to guarantee some sort of social optimality, but the question also is important for a positive analysis, for determining the optimal size of the industry is closely related to analyzing the size that will emerge in competitive equilibrium. Thus the subject of this paper would seem important to several groups, including students of the financial industry, that industry’s regulators, and both macroeconomists and macroeconomic policy makers. However, it is only recently that economic theory has begun to address this important issue. This is, in large part, due to the fact that the financial sector has occupied a rather secondary position in formal macroeconomic theory for most of the past few decades. In Patinkin’s (1965) neo-classical framework, the financial sector was limited to the demands and supplies of money and bonds; financial institutions played no significant role. Subsequent developments, such as Brunner and Meltzer (1968) and Tobin (1969), continued to assign to financial institutions only a minor role in determining macroeconomic equilibrium.
This view began to change with Bernanke’s (1980) evidence that the Great Depression was at least partly the result of a reduction in the banking sector’s ability to perform its evaluation and monitoring role. Bernanke’s subsequent work with Gertler (1988, 1989) showed the importance of introducing into macroeconomic analysis the insights of the growing banking and intermediation literature. In particular, the work of Leland and Pyle (1977), Diamond (1984), and others had clearly established the importance of the monitoring function undertaken by such institutions. Since this earlier work, a number of articles have developed a macroeconomic role for banks, emphasizing the value added by banks and often spotlighting banks’ possible role in exacerbating business cycles and credit crunches.
Once one accepts the notion that the financial sector is important for real economic activity, however, some obvious questions come to mind. What is the appropriate or optimal size of the financial sector? What does that size depend on? How does it respond to changes in economic conditions? How do departures from the optimal size affect the economy? Holmstrom and Tirole’s recent 1997 contribution is the first step in addressing some of these questions with their analysis of the appropriate allocation of capital in a competitive market. Their results are provocative but are limited by their partial equilibrium setting.
In this paper, we develop a model of the economy similar in spirit to the Holmstrom and Tirole framework but in which all results are obtained in a general equilibrium framework, allowing us to address the interaction of the financial and real sectors more completely than has been done heretofore. We show that there is an optimal size for the financial sector, and that depends on some characteristics of the production and monitoring technologies. Interestingly, the optimal size of the financial sector is unrelated to the economic cycle and is not causally linked to things such as credit cycles, a result that contrasts sharply with those emerging from the partial equilibrium models of Holmstrom and Tirole and of Bernanke and Gertler. The general equilibrium framework also permits us to obtain other new results. For example, the size of the financial sector affects not only the level of output but also its growth rate. Also, both the magnitude and, more interestingly, even the direction of the response of aggregate consumption to a change in the financial sector’s size depends on the current size of the financial sector relative to that of the economy as a whole and on several parameters of various behavioral functions. Finally, our results have implications for the regulation of financial intermediaries’ capital ratios.
Section II of the paper presents the background for our approach. Section III builds a simple static model to establish some fundamentals and lay the foundation for the dynamic model. Section IV presents the dynamic model. Section V concludes the paper.
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