Volatility and financial intermediation

We consider an economy where risk neutral banks provide intermediation services and risk neutral producers demand credit to finance their working capital needs. Our model blends costly state verification with imperfect enforcement power. We show that a weak legal system combined with high information verification costs leads to large, first-order effects of volatility on production, employment and welfare. A calibration illustrates that a 1% increase in the coefficient of variation of productivity shocks would reduce welfare by more than 1%. We suggest that legal and information problems explains why volatility has profound effects on emerging market economies.