Bank Lending and the Term Structure∗

We study the implications of bank lending for the term structure. Specifically, we consider how resources are optimally allocated between a banking sector and a risky sector. To do so, we use a “two trees” framework with a risky and risk free sector, in which capital moves sluggishly between the two. We characterize equilibrium and illustrate how financial flexibility affects the term structure and social welfare. We develop a pricing equation for the equilibrium term structure and characterize the steady state distribution of growth rates in the economy. In addition, we demonstrate by example how financial innovation may increase or decrease the growth rate of the economy, how the effectiveness of monetary policy depends on the current state of the economy, and how a central bank can reduce the probability that the economy is in a low growth state. ∗Preliminary and incomplete: Please do not distribute. A previous draft of this paper was entitled The Credit Channel and the Term Structure. We thank Jonathan Berk, Mr. 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]