Introduction

The Miller–Modigliani theorem asserts that, in a setting of perfect capital markets, economic decisions do not depend on financial structure. An implication is that the addition of financial intermediaries to this type of environment has no consequence for real activity.

A number of recent papers [e.g., Bernanke (1983), Blinder and Stiglitz (1983), Boyd and Prescott (1983), Townsend (1983), and Williamson (1985)] have questioned the relevance of this proposition, even as an approximation, for macroeconomic analysis. Instead, they revive the view of Gurley and Shaw (1956), Patinkin (1961), Brainard and Tobin (1963), and others that the quality and quantity of services provided by intermediaries are important determinants of aggregate economic performance. The basic premise is that, in the absence of intermediary institutions, informational problems cause financial markets to be incomplete. By specializing in gathering information about loan projects, and by permitting pooling and risk-sharing among depositors, financial intermediaries help reduce market imperfections and improve the allocation of resources. Thus, changes in the level of financial intermediation due to monetary policy, legal restrictions, or other factors may have significant real effects on the economy. For example, Bernanke (1983) argued that the severity of the Great Depression was due in part to the loss in intermediary services suffered when the banking system collapsed in 1930–33.

The objective of this paper is to provide an additional step toward understanding the role of financial intermediaries (hereafter, simply “banks”) in aggregate economic activity.