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Financial intermediation as delegated monitoring: a simple example



Financial Intermediation as Delegated Monitoring: A Simple Example Financial Intermediation as Delegated Monitoring: A Simple Example Douglas W. Diamond B anks and other financial intermediaries are the main source of external funds to firms. Intermediaries provided more than 50 percent of exter- nal funds from 1970 to 1985 in the United States, Japan, the United Kingdom, Germany, and France (Mayer 1990). Why do investors first lend to banks who then lend to borrowers, instead of lending directly? What is the financial technology that gives the banks the ability to serve as middleman? To answer these questions, this article presents a simplified version of the model in Financial Intermediation and Delegated Monitoring (Diamond 1984).1 The results explain the key role of debt contracts in bank finance and the importance of diversification within financial intermediaries. The framework can be used to understand the organizational form of intermediaries, the role of banks in capital formation, and the effects of policies that limit bank diversification.2 Financial intermediaries are agents, or groups of agents, who are delegated the authority to invest in financial assets. In particular, they issue securities in order to buy other securities. A first step in understanding intermediaries is to describe the features of the financial markets where they play an important role and highlight what allows them to provide beneficial services. It is im- portant to understand the financial contracts written by intermediaries, how the contracts differ from those that do not involve an intermediary, and why these are optimal financial contracts. Debt contracts are central to the understanding The author, the Theodore O. Yntema Professor of Finance at the University of Chicago, Graduate School of Business, is grateful to Tony Kuprianov, Jeff Lacker, and John Weinberg for helpful comments. The views expressed are those of the author and do not necessarily reflect those of the Federal Reserve

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