Financial Intermediation and Delegated Monitoring

TLDR

The paper develops a theory of financial intermediation that minimizes monitoring costs to resolve incentive problems between borrowers and lenders, and analyzes how diversification further mitigates these problems. It characterizes the costs of providing incentives for delegated monitoring by a financial intermediary and examines how diversification reduces those costs. Diversification lowers monitoring costs even in a risk‑neutral economy, debt contracts with costly bankruptcy are optimal, and the results inform intermediaries’ portfolio and capital structure decisions.

Abstract

This paper develops a theory of financial intermediation based on minimizing the cost of monitoring information which is useful for resolving incentive problems between borrowers and lenders. It presents a characterization of the costs of providing incentives for delegated monitoring by a financial intermediary. Diversification within an intermediary serves to reduce these costs, even in a risk neutral economy. The paper presents some more general analysis of the effect of diversification on resolving incentive problems. In the environment assumed in the model, debt contracts with costly bankruptcy are shown to be optimal. The analysis has implications for the portfolio structure and capital structure of intermediaries.