Allowing for Risk Choices in Diamond's "Financial Intermediation as Delegated Monitoring"

Martin Hellwig

No 98-04, Sonderforschungsbereich 504 Publications from Sonderforschungsbereich 504, Universität Mannheim, Sonderforschungsbereich 504, University of Mannheim

Abstract: The paper studies the relative efficiency of intermediated finance and direct finance in a variant of Diamond's (1984) model of ''financial intermediation as delegated monitoring''. Project sizes are taken to be variable so a choice must be taken on whether to fund a small number of projects on large scale or a large number of projects on a small scale. In the absence of effective advance commitments to lending policies, this introduces an additional agency problem of intermediated finance as the well known excessive-risk-taking effect of debt finance induce intermediaries to underdiversify. The paper analyses the impact of this effect on the performance of intermediated finance under various assumptions about project technologies. Most strikingly, in the case of fixed monitoring costs and project technologies with stochastic constant returns to scale, there is no diversification at all, and intermediated finance is worse than direct finance. In this very case, with effective advance commitments to lending policies, an optimal intermediation arrangement would exploit both, the scope for diversification and the scale effects in monitoring so as to attain approximately first-best outcomes when there are many available projects.

Pages: 39 pages
Date: 1998-03-10
New Economics Papers: this item is included in nep-mic
Note: It is a pleasure to acknowlegde helpful discussions with Vittoria Cerasi, Christian Laux, and Paul Povel. Financial support from the Deutsche Forschungsgemeinschaft is gratefully acknowledged.
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Working Paper: Allowing for risk choice in Diamond's "Financial intermediation as delegated monitoring" (1998)
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