Financial Development and Asset Valuation: The Special Case of Real Estate

Abstract

This paper investigates the impact of financial development on asset valuation. We model the agency theoretic perspective of risk averse investors and financiers in a general equilibrium framework using the principle of rational expectations. We focus on real estate, as it constitutes a special case of complete market contracting where adverse selection and moral hazard are easily mitigated. Our results illustrate an increase in pareto-efficiency, as financial architecture advances from (i) banks to capital markets; and (ii) plain vanilla debt to innovative one with participation clauses. This is attributed to the reduction in agency costs and cross-sectional risk-sharing, leading to an increase in the value of property. Our results predict that an optimal financial system will orient itself towards efficient financial contracts, irrespective of its source of origination. We also rationalize the co-existence of banks and capital markets, and generalize our results to the corporate sector of the economy under a set of restrictive conditions.

Keywords: Financial Deepening, Financial Innovation, Financial Liberalization, Risk Management

JEL Classification: D58, G12, G2, G32, O12, O16, R13