Banking and Asset Prices ∗

We embed the notion of banks as monitors into a “two trees” framework, and consider how resources are optimally allocated between an intermediated banking sector and a risky sector, given that capital moves sluggishly between the two. We characterize equilibrium as a function of the relative size of the banking sector — the bank share — and the speed at which capital can move in and out of that sector — the financial flexibility. There are three main implications of the model. First, the bank share and financial flexibility are both important determinants of asset prices. Price-dividend ratios are lower, the higher the financial flexibility and the effect on price-dividend ratios of a shock depends on whether the shock arises in the banking sector or in the risky sector. Higher financial flexibility leads to a steeper term structure of interest rates and an inverted term structure is associated with low real growth rates. Second, the relationship between financial flexibility and real growth rates in the economy is ambiguous; high financial flexibility may lead to either higher or lower growth rates. Third, the speed at which capital actually moves into and out of the banking sector is a highly nonlinear function of the bank share. An implication is that the bank share may remain perpetually low after a shock to the banking sector. In such cases, the value of financial flexibility may be extremely high. ∗A previous draft of this paper was entitled The Credit Channel and the Term Structure. We thank Jonathan Berk, Bob Goldstein, Dwight Jaffee, Hayne Leland, Dmitry Livdan, Nancy Wallace and James Wilcox for helpful comments. †Haas School of Business, U.C. Berkeley, [email protected]. ‡Haas School of Business, U.C. Berkeley, [email protected]. §Haas School of Business, U.C. Berkeley, [email protected].