Distortions, misallocation and the endogenous determination of the size of the financial sector

We present a model of heterogeneous firms and misallocation in which financial frictions are partially overcome if more human resources are devoted to intermediation, at the cost of having fewer resources employed in directly productive activities. Not only does an inefficient financial sector result in an inefficient final good sector; an inefficient final good sector results in an inefficient financial sector. Exogenous inefficiencies in the productive sector generate decreased demand for financial services, which translates into a smaller and less efficient financial sector, worsening the resource allocation in the productive sector. This direction of causality seems in line with cross-country evidence.