Intermediation, Capital Immobility, and Asset Prices

We introduce intermediation frictions into a Lucas (1978) asset pricing model in order to study the effects of low capital in the intermediary sector on asset prices. Our model shows that low intermediary capital can increase risk premia, Sharpe ratios, volatility and comovement among intermediated assets. Reductions in intermediary capital also lead to a flight-to-quality in which intermediaries’ investors withdraw their funds and purchase bonds. The model thereby replicates observed asset market behavior during aggregate liquidity crises. In a dynamic context, we show that intermediaries will hedge against periods of low capital, and a liquidity factor driving asset returns arises from such hedging. We calibrate the model to quantify the asset market effects of low intermediary capital.

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