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Optimal banking with delegated monitoring

Nemanja Antic and Tai-Wei Hu

Journal of Economic Theory, 2024, vol. 222, issue C

Abstract: We propose a model of financial intermediation based on delegated monitoring, where firms' returns are private information that lenders can ascertain through costly state verification. Our model has two key features: lenders cannot commit to their verification strategies and there are aggregate shocks. Simple debt contracts are Pareto optimal with or without intermediation. We show that the benefits of intermediation can be limited by financial instability in the presence of aggregate shocks. However, a well-designed resolution mechanism ensures the Pareto optimality of financial intermediation, and a bail-out policy can restore financial stability.

Keywords: Banking regulations; Costly state verification; Delegated monitoring (search for similar items in EconPapers)
JEL-codes: E44 E58 G21 (search for similar items in EconPapers)
Date: 2024
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Persistent link: https://EconPapers.repec.org/RePEc:eee:jetheo:v:222:y:2024:i:c:s0022053124001108

DOI: 10.1016/j.jet.2024.105904

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