Banking and Asset Prices in a Flexible-Tree Economy

We embed the notion of banks as monitors who reduce risk into a “two-trees” framework, and consider an economy in which capital can be moved between the trees. We characterize how resources are optimally allocated between the intermediated banking sector and a risky sector 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 — financial flexibility. The model has three main implications: First, the bank share and financial flexibility affect asset prices; for example, price-dividend ratios are lower the higher the financial flexibility, and shocks to the economy affect the slope of the term structure in a predictable way. Second, the relationship between financial flexibility and real growth rates is ambiguous; high financial flexibility may lead to either higher or lower growth rates. Third, the speed at which capital 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. Methodologically, our paper contributes to the two-trees literature by allowing for reallocation of resources between trees in a tractable framework; this flexible-tree approach allows for stationary share distributions.