Intermediation Capital 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 with-draw their funds and purchase bonds. We calibrate our model and find that the effects are sizable: risk premia can double when moving from states of the world where intermediary capital is plentiful to states where intermediary capital is scarce. We simulate our model to measure the average effects of interme-diary capital on asset prices. In our simulations, the economy does not spend sufficient time in the low intermediary capital states, so that average effects on asset prices are small. Our model suggests that intermediation frictions are first order to understand financial crises and episodes of market illiquidity, but are second order to understand the average equity risk premium