Publication Date: April 1999
This paper considers the eﬀiciency of ﬁnancial intermediation and the propagation of business cycle shocks in a model of long-term relationships between entrepreneurs and lenders, where lenders may be constrained in their short-run access to liquidity. When liquidity is low, relationships are subject to breakups that lead to loss of joint surplus. Liquidity outflows cause damage to ﬁnancial structure by breaking up relationships, and damage persists due to frictions in the formation of new relationships. Feedbacks between aggregate investment and the structure of intermediation greatly magnify the eﬀects of shocks. For large shocks, ﬁnancial collapse may become inescapable in the absence of external intervention.
Published in Journal of Monetary Economics (September 2003), 50(6): 1215-1241 [DOI]