RESEA RC H IN STITU TE Intra - Financial Lending , Credit , and Capital Formation

This paper examines the e↵ects of intra-financial lending – claims between financial institutions – on aggregate investment and credit to the non-financial sector in the United States. Building on Montecino, Epstein, and Levina (2014) we document a large growth in intra-financial assets beginning in the early 1980s. Using a vector autoregression model, we find that intra-financial lending is negatively related to gross capital formation and present evidence that this operates through a credit channel. However, we also find evidence of a structural break around the year 2000. Rolling impulse response functions suggest the presence of two alternative regimes over the post-war period: a “capital diversion” regime in which credit to the non-financial sector and intra-financial lending are substitutes, as well as a financial bubble regime in which credit and intra-financial lending are complements. In the latter case, credit to the non-financial sector and intra-financial lending appear to feed each other in an unsustainable bubble process. In neither case do we find macroeconomic evidence in support of the financial e ciency view that increased intra-financial lending reflect financial innovations associated with more e cient risk bearing, liquidity provision, and credit allocation. JEL classification: G01, G10, G20