Financial Markets, Intermediaries, and Intertemporal Smoothing (Revised 14-96)

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Abstract
The returns of assets that are traded on financial markets are more volatile than the returns offered by intermediaries such as banks and insurance companies. This suggests that individual investors are exposed to more risk in countries which rely heavily on financial markets. In the absence of a complete set of Arrow-Debreu securities, there may be a role for institutions that can smooth asset returns over rime. In this paper, we consider one such mechanism. We present an example of an economy in which the incompleteness of financial markets leads to underinvestment in reserves whereas the optimum, for a broad class of welfare functions, requires the holding of large reserves in order to smooth asset returns over time. We then argue that a long-lived intermediary may be able to implement the optimum. However, the position of the intermediary is fragile; competition from financial markets can cause the intertemporal smoothing mechanism to unravel, in which case the intermediary will do no better than the market.

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