The Role of Banks in Influencing Regional Flow of Funds

Abstract

Although the recent performance of the U.S. macroeconomy is being hailed as "the longest modern peacetime expansion s n failures of depository institutions have been closely linked to certain depressed productive sectors in the country. The most stark examples can be found in the depressed farm-belt and oil-producing regions. Observations indicate that financial firms do not or cannot diversify against industry-specific risk when choosing their loan portfolios. Such behavior may be explained by extensive government regulation of the industry's scale and scope or by technological costs of intermediating credit that encourage specialized lending by region or by industry. This paper does not attempt to formally explain why depository institutions engage in specialized lending; rather, it examines some implications of regional and sectoral banking in terms of macroeconomic perf~rmance.~ It considers the short-run implications of bank-capital immobility when banks produce real services in channeling the flow of funds into investments. We illustrate how regional banking conditions can affect the mix of aggregate investment and the level of future aggregate output in the absence of macroeconomic fluctuations. Given the current deregulatory trend in structural policy changes, the nature of the financial services industries has come under intense scrutiny. Recent banking literature has formalized how financial contracts are related to imperfect information. A recurring theme has been that when information is costly, the quantity and nature of external finance has allocative consequences. Diamond (1984) demonstrates how financial intermediaries (hereafter referred to as banks) can improve the efficiency of capital markets by diversifying and thus minimizing information costs; however, perfect diversification makes bank capital and the dispersion of bank asset returns irrelevant to bank portfolio choice. These strong informational assumptions allow the intermediation process to work more smoothly than we observe. If these conditions are not met, bank capital and the risk of bank assets affect bank profitability. Bernanke and Gertler (1987) show how the inability to eliminate variability in portfolio returns implies that "health" of a'bank's balance sheet can affect the flow of funds to risky bank investments. In their model, depositors cannot observe the ex-post returns on bank projects at any cost and bank capital must absorb random asset returns; insufficient bank capital may constrain banks from investing in risky but profitable investments. In a similar framework, Samolyk (1989) examines how the interest-rate risk associated with the maturity transformation in bank portfolios affects bank asset management. This paper will analyze the implications of imperfect information for investment in a decentralized banking ~ystern.~ We present an intertemporal model of banking similar to that of Bernanke and Gertler. Bankers possess a specialized technology that allows them to channel resources to investment projects that would not be funded in direct credit markets. They also have information about their portfolio returns. Unlike Bernanke and Gertler , this analysis attempts to incorporate the notion that there is more than one productive sector in the economy. We assume that in the short run, bank