Why is a well-developed fi nancial sector important and what eff ect does it have on the risk in an economy? According to the development literature, financial development leads to economic growth because it allows intermediaries to carry out tasks such as reducing investment costs or pooling capital more efficiently. However, in this view of financial development there is no channel for intermediaries either to avert or to create systemic risk. By contrast, in the banking literature, the fundamental role of intermediaries is to transform risk. Specifically, intermediaries have the expertise to reallocate investment capital, and so they provide a link between capital owners and entrepreneurs, allowing both to achieve the optimal mix of risk and returns.
Intermediaries also have the expertise to change the risk of existing investments by monitoring. From the perspective of this literature, financial development is identifi ed with financial flexibility the effciency with which capital can be reallocated and monitored. In the wake of the recent financial crisis, understanding the economy-wide impact of this transformation role of intermediaries on risk, capital allocation, and asset prices is crucial.
In this paper, we focus on these two special properties of the financial sector financial flexibility and risk transformation|and show in a parsimonious dynamic general-equilibrium model how they lead to a rich set of implications that are broadly consistent with observed market behavior. Specifi cally, there is a direct connection between the degree of financial flexibility in an economy, the size of the banking sector, the value of intermediation, expected returns in the market, real growth rates, intra-economy capital flows (including "flight-to-quality"), and the risk of bank crashes.
In our framework, the economy has an optimal level of intermediated capital, which depends on technological processes and on any nancial frictions that prevent instantaneous adjustment. In competitive equilibrium, intermediaries cause capital to flow to bring the economy towards this optimal fraction. There is therefore a close relation between time-varying real and fi nancial variables, on the one hand, and the size, flow and value of intermediated capital, on the other.