Intra-Financial Lending, Credit, and Capital Formation

This paper examines the effects of intra-financial lending – claims between financial institutions – on aggregate investment and credit to the non-financial sector in the United States. Building on Montecino, Epstein, and Levina (2014) we document a large growth in intra-financial assets beginning in the early 1980s. Using a vector autoregression model, we find that intra-financial lending is negatively related to gross capital formation and present evidence that this operates through a credit channel. However, we also find evidence of a structural break around the year 2000. Rolling impulse response functions suggest the presence of two alternative regimes over the post-war period: a “capital diversion†regime in which credit to the non-financial sector and intra-financial lending are substitutes, as well as a financial bubble regime in which credit and intra-financial lending are complements. In the latter case, credit to the non-financial sector and intra-financial lending appear to reinforce each other, although unsustainably. Our results suggest that increased intra-financial lending does not reflect financial innovations associated with more efficient risk bearing, liquidity provision, and credit allocation.