Financial Intermediation with Heterogeneous Agents: Transitional Dynamics and Policy Responses

Traditionally, the literature on financial intermediation and credit channels, especially credit crunches, emphasized the relation between banks and entrepreneurs requiring credit, neglecting the funding of banks. With this paper, we want to be much more precise in this respect and study the impact of funding on credit. Indeed, regulation that has become world wide with the Basle Accord puts limits on the amount of loans banks can give. How much equity the banks hold depends in particular on how much households are willing to buy equity in addition to deposits. In our model economy, households have heterogenous asset holdings because they have different labor histories and because some get credit (and among those, the return on investment is stochastic). Households invest in bank deposits and bank equity, and banks maximize profits while following regulations. A central bank conducts the monetary policy and regulates the banks. Households that do not enter entrepreneurship because they have been turned down by banks have funds available for equity and deposits. Therefore, when banks need to reduce their loan portfolio, the displaced entrepreneurs become new equity holders, thereby acting as “automatic stabilizers”. However, banks typically cut loans as a consequence of their loan portfolio becoming too risky, and households may then want to hold less equity in banks that are now more risky. Whether banks have to tighten credit a lot or not now depends very much on the distribution of assets across households. We solve this very rich model using some innovative numerical methods, in particular for the transitional dynamics that may lead an economy into a credit crunch. We then look what monetary and regularly policies may help the economy out of a credit crunch, emphasizing in particular the delays of the responses. We find that the endogenous distribution of assets has strong implications that should not be neglected in future research.