Abstract

In the run up to the financial crisis, the essential functions financial intermediaries played seemed to become less important. Commercial and industrial loans, as well as residential mortgages, the quintessential banking products, were securitized and sold. At the same time, the “skin in the game” intermediaries held in their activities (such as securitizations) diminished, while their leverage increased. Some have suggested these developments stemmed from rising agency problems in the financial sector. Instead, we attribute them to rising liquidity in real asset markets. Under a variety of circumstances, prospective liquidity tends to enhance firm leverage, which crowds out both internal and external corporate governance as supports to debt. This tends to make debt returns more skewed. We develop a general theory of the interaction between intermediary activities, intermediary capital structure, and real asset market liquidity.

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• Keyword(s):
• equity markets 41
• finance 247

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