Abstract

In this paper, I build a model where financial intermediation slows the flow of capital. Investors optimally learn from intermediary performance to allocate capital toward profitable intermediaries. Intermediaries reach for yield, i.e invest in high tail risk assets, in an attempt to drive flows and reduce liquidation risk. Reaching for yield is stronger among intermediaries with weak opportunities, resulting in a reduction in the informativeness of performance; investors take longer to learn and capital flows become less responsive to performance. Capital becomes slow moving because the reach for yield dampens learning. The model predicts capital immobility to be stronger when tail risk is high; when tail risk is underpriced; and in asset classes with large cross-sectional variation in tail risk exposures.

Link to the full-text working paper