Intermediation Costs and Welfare

he welfare implications of moderate inflation. The aggregate welfare gain of reducing intermediation costs from 3.9 percent (US level) to 1 percent is about 3.5 percent of equivalent consumption to the baseline economy. We also show that the welfare gains are not evenly distributed across agents. For households at the bottom 10 percent of wealth, the average welfare gain is about 11 percent of equivalent consumption.

JEL Classification: E60; G Keywords: Intermediation costs; Distribution; Welfare 1 Introduction The wedge between the loan and the deposit rate (i.e, the spread rate) varies significatively across countries and it is also high in some developed countries. Data from the World Development Indicators show that while the spread rate is about 1.06 percentage points in the Netherlands, it is roughly 40 percentage points in Brazil. A careful empirical investigation by D´ ıaz-Gim´nez, Prescott, Fitzgerald, and Alvarez (1992) e shows that for collateralized loans the average interest rate is nearly 4 percentage points higher than the return on bank deposit in the United States. For uncollateralized loans the spread rate is in excess of 10 percent. Clearly, not all the difference in loan and deposit rates comes from intermediation costs. Demirg¨ c-Kunt and Huizinga u¸ (1999) show that the net interest margin can be decomposed into banks’ profits plus overhead costs, loan loss provisions and taxes, minus non interest income, all divided by total assets. We use the sum of overhead costs and taxes as a share of total assets to denote intermediation costs. Therefore, as in Barth, Caprio, Jr, and Levine (2006), we interpret greater overhead costs as reflecting operational inefficiency. Figure 1a graphs overhead costs versus per capita GDP for some selected countries, and figure 1b plots overhead costs over time in Brazil, Ireland, and the United States. As we can observe, overhead costs as a percent of total assets is roughly 3.5 percent in the United State, 8 percent in Brazil and only 0.7 percent in Ireland.

Figure 1: Panel (a): Overhead costs and GDP per capita (2004 US$). Panel (b):

Overhead costs in Brazil, Ireland, and United States. Source: World Development Indicators and Database on Financial Structure and Economic Development (Demirg¨ cu¸ Kunt and Levine, 2000).

(a) (b) x 3.5 0. Brazil United States Ireland 0. 0. Intermediation costs might reflect explicit and implicit financial sector taxes (e.g., tax on financial transactions, on intermediary profits, or inflation), institutional factors (e.g., bribes, corruption), and bank inefficiency. In this this paper we study the welfare implications of intermediation costs. We address this problem by constructing an economy based on a standard neoclassical growth model where individuals experience uninsurable idiosyncratic shocks on labor productivity, financial intermediation is costly, and individuals face an endogenous borrowing limit (see Kehoe and Levine, 1993).1 Households who choose to default on their debt are excluded from future In appendix A we also provide simulations of an economy with a natural borrowing limit based on Aiyagari (1994).

intertemporal trade.

Households wish to smooth consumption over time and in our economy they do that by making deposits to a financial intermediary in good times and by running down credit balances or getting loans in bad times. Financial intermediation is, however, costly. There is a wedge between the loan and the deposit interest rate, and interest payments on loans are higher than the return on deposits. We calibrated model parameters to match key statistics of the United States economy and performed counter-factual experiments. Reducing intermediation costs leads to two effects. For a given interest rate, this implies that borrowing costs decrease. There is an expansion in net borrowers’ consumption possibility frontier, but this also affects households with positive net assets. There is a positive probability that such agents might face bad shocks on labor productivity and might need to rely on borrowing to smooth consumption. Additionally to this direct effect, there is also an indirect one: lower intermediation costs imply an increase in the demand for loans, and therefore the interest rate rises. This increases borrowing costs and offset part of the direct effect and it also increases interest income, improving welfare of net savers.

Our welfare analysis focuses not only on stationary equilibria but it also takes into account the whole transitional dynamics. This is important for at least two reasons: first because the transition is slower in this framework and abstracting from it can lead to misleading welfare calculations; and second because there is mobility in wealth in this economy and comparing, for instance, the agent with median wealth in two stationary equilibrium does not guarantee that we are comparing the same household. We show that the welfare implications of intermediation costs are large.

The aggregate welfare gain, in which we calculate the average welfare gain of all agents, of reducing intermediation costs from 3.9 percent (United States level) to percent (level observed in the 10 percentil of countries with smallest overhead costs) corresponds to about 3.5 percent of consumption equivalent of the baseline economy.

This is at least about 3.5 times larger than previous estimates of:2 (i) reducing the capital income tax rate from 36 percent to zero percent; (ii) reducing inflation from to 0 percent; and (iii) eliminating all business cycles fluctuations. We also show that the welfare implications are not evenly distributed across agents. For the 10 percent poorer households the average welfare gains corresponds to 11 percent of their baseline consumption. However, for the 10 percent richer households the average welfare gains is roughly 1.1 percent of their baseline consumption.

We do not explicit provide a rationality behind the existence of banks in the economy. Instead we assume a given costly intermediation technology and take regulation as given.3 Our goal is not to provide a theoretical foundation of financial intermediaries and bank regulation, but instead to evaluate how costly intermediation affects the ability of households to smooth consumption over time and its welfare implications in a heterogenous agents setting.4 In this respect our paper is related to a large literature on supply-side economics, such Lucas’ (1990) article on the welfare effects of reducing capital income taxation.5 There is also a large literature that studies the impact of financial reform on long run productivity and economic growth (e.g., See subsection 3.5 for details and references.

Based on Townsend (1978), Greenwood and Jovanovic (1990) build an economy in which financial institutions arise endogenously to allow risk sharing and consumption smoothing by: (i) Collecting and analyzing information; (ii) pooling risk over a large number of traders; and (iii) allocating better the resources in high return investments. See also Bencivenga and Smith (1991) and Boyd and Smith (1998). See Diamond and Dybvig (1983) for a theoretical justification of bank regulation.

In our quantitative analysis, we also measure intermediation costs by taxes and overhead costs only. We do not consider bank profits or loan loss provisions as intermediation costs.

See also Lucas (2000) who studies the welfare costs of inflation.

There is also an important literature that studies empirically the relationship between financial Amaral and Quintin (2005), Castro, Clementi, and MacDonald (2004), Erosa and Hidalgo-Cabrillana (2007), and Antunes, Cavalcanti, and Villamil (2008)). Our positive question is related to this literature, but we focus on the effects of intermediation costs on consumption smoothing and welfare, rather than on entrepreneurship and economic development. From our knowledge, we are the first to quantify the welfare implications of intermediation costs on a standard growth model with heterogenous agents. The paper proceeds as follows. Section 2 describes the model economy and defines the competitive equilibrium. Section 3 describes the model calibration and contains policy experiments designed to evaluate the welfare effects of benchmark changes in intermediation costs. Section 4 concludes.

There are three sectors in this economy: the banking sector, the production sector, and the household sector. The economy is inhabited by a continuum of infinitelived households who are ex-ante identical. Households face idiosyncratic shocks on their labor productivity but there is no aggregate uncertainty. Banks only role is to intermediate among households, but intermediation is costly. The production sector is characterized by a technology that exhibits constant returns to scale. The produced good can be used for consumption or investment. Below we describe the economy in detail.

development and economic development. See King and Levine (1993), Levine (1997), and Rajan and Zingales (1998).

Interestingly, Chia and Whalley (1999) study a similar question to ours and provide some welfare numbers for changes in intermediation costs with a different framework. They consider a finite period lived economy without production, idiosyncratic uncertainty, and borrowing constraints.