Unbundling financial imperfections: Lending frictions vs. trading frictions

Two essential imperfections determine the degree of the financial sector development in an economy: lending frictions, which constrain the ability to extend loans to borrowers; and, trading frictions, which constrain the trading of these loans in secondary markets. I develop a dynamic general equilibrium model where long-term investment is the engine of growth to study macroeconomic consequences of financial development. In the model, long-term loans are extended to entrepreneurs in a primary market and then traded in a secondary market among financiers. In competitive equilibria, reductions in either lending or trading frictions enlarge the financial sector. Although financial deepening through low-cost lending is always welfare improving, financial deepening stimulated by low-cost trading could be detrimental to the society. I illustrate that a model qualitatively consistent with the U.S. financial development episode of the last 30 years should exhibit disproportionately large reductions in trading frictions relative to lending frictions.