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working paper
department
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FINANCIAL INTERMEDIATION, LOANABLE FUNDS
AND THE REAL SECTOR
Bengt Holmstrom
Jean Tirole
L
95-1
Sept. 1994
massachusetts
institute of
technology
50 memorial drive
Cambridge, mass. 02139
FINANCIAL INTERMEDIATION, LOANABLE FUNDS
AND THE REAL SECTOR
Bengt Holmstrom
Jean Tirole
95-1
Sept. 1994
MASSACHUSETTS INSTITUTE
OF TECHNOLOGY
MAR 2
9 1995
LIBRARIES
95-1
FINANCIAL INTERMEDIATION,
LOANABLE FUNDS
AND THE REAL SECTOR*
Bengt Holmstrom*
Jean Tirole*"
Sept. 28, 1994
*We want
to thank
Marco Pagano
for very helpful
comments on an
National Science Foundation for financial support.
"Department of Economics, Massachusetts
"*IDEI, Toulouse, and
CERAS,
Paris.
Institute
of Technology.
earlier draft
and the
ABSTRACT
We
study an incentive model of financial intermediation in which firms as well as
intermediaries are capital constrained.
We
analyze
how
the distribution of wealth across
firms, intermediaries and uninformed investors affects investment, interest rates and the
intensity of monitoring.
We
show
that all
forms of ^capital tightening
(a credit crunch, a
collateral squeeze, or a savings squeeze) hit poorly capitalized firms the hardest, but that
interest rate effects
and the intensity of monitoring will depend on relative changes
various components of capital.
The
predictions of the model are broadly consistent with the
lending patterns observed during the recent financial crises in Scandinavia.
shows
that in an unregulated
The model
environment, the market response to a credit crunch
solvency ratios of intermediaries
in the
to
decline,
suggesting that a
is to
more permissive
adequacy requirement may be the appropriate regulatory response as well.
also
allow
capital
Introduction
1
Recent events
in
Scandinavia strongly support the view that there are important links
between the financial and the
to
real sectors
of an economy.
As
interest rates
were pushed up
defend the currencies of these countries, the value of real assets dropped dramatically,
forcing banks to contract lending both because the value of firms' collateral had dropped and
because the banks themselves were
Small firms were hardest
hit
left
with insuffient equity after substantial loan losses.
by the ensuing credit crunch; the banks routinely abandoned
them. By contrast, large firms were often extended additional credit, sometimes as part of
a major restructuring of both sides of their balance sheet. Today, as the financial sector
returning to profitability and begins to rebuild
rates), the
Firms,
problem
particularly
is
shifting
its
equity (mainly thanks to lower interest
from inadequate credit supply
have
small ones,
difficulties
is
demand.
to inadequate credit
obtaining credit even
for
day-to-day
operations, not because banks feel pressured to reduce lending any further, but because these
firms are seriously short of collateral.
On
the other hand, large firms, which
would be
acceptable risks, are busy consolidating their balance sheets and paying off excess debt.
Banks have
started to respond to the shortage of collateral
information intensive lending, that
is,
by
towards lending that
shifting resources
relies
towards more
on an evaluation of cash
flows rather than just collateral.
The purpose of this paper
is to
construct a simple equilibrium model of credit that can
reproduce some of the stylized facts reported above and thereby shed light on the role of
different kinds of capital constraints. In the
capacity; firms that take on too
stake in the financial
much
outcome and
debt
model a firm's net worth determines
in relation to equity, will
will therefore not
behave
diligently.
its
debt
not have a sufficient
Assuming invc^rn
ent
projects are of fixed size, only firms with sufficiently high net worth will be able to finance
investments directly. Firms with low net worth have to turn to financial intermediaries,
1
who
can reduce the demand for collateral by monitoring more intensively. Thus, monitoring
a partial substitute for collateral. However,
all
firms cannot be monitored in equilibrium,
because intermediaries, like firms, must invest some of their
to
be credible monitors. Equilibrium
paid on monitoring capital
and aggregate intermediary
We
—
is
in the
is
own
capital in a project in order
market for monitoring
—
the interest
premium
then determined by the relative amounts of aggregate firm
capital.
are primarily interested in the effects that reductions in different types of capital
have on aggregate and sectoral investments,
interest rates,
(market) and indirect (intermediated) finance.
The novelty
above depend on the the financial
behavior that
is
status of both firms
and the relative roles of
in
our analysis
is that
direct
the effects
and intermediaries. The model features
broadly consistent with the Scandinavian experience: firms with substantial
net worth can rely on cheaper, less information intensive (asset backed) finance; highly
leveraged firms
demand more information
intensive finance (monitoring); if there
is
an
excess of monitoring capital relative to firm capital, banks shift to lending technologies that
involve more monitoring;
to get
squeezed.
adequacy
ratios.
when monitoring
In equilibrium,
extensively from
(1992),
norms
poor firms are the
first
intermediaries must satisfy market determined capital
Interestingly, these capital
rationale for looser banking
Our model
capital decreases, capital
adequacy
ratios are procyclical, suggesting a
in recessions.
builds on the previous literature on capital constrained lending, borrowing
its
who employ
insights.
the
net worth determines
The papers most
closely related to ours are
same basic moral hazard model
its
'See Jaffee-Russell
1
as
we do
to analyze
by Hoshi
how
et al
the firm's
choice between direct and indirect financing, and by Diamond
(1976),
Stiglitz-Weiss
(1981),
Bester-Hellwig (1987) on
-„icdit
Diamond (1991), Hoshi et al (1992) on capital constrained
borrowing; Diamond (1984), Besanko-Kanatas (1993) on intermediation; and HolmstromWeiss (1985), Williamson (1987), Bernanke-Gertler (1989), and Kiyotaki-Moore (1993) on
rationing; Bester (1985, 1987),
agency costs
that
amplify the business cycle.
(1991),
who
studies this choice as a function of the firm's reputation for repaying debt
However,
reputation capital).
is
the
in neither
main feature we are interested
closely related in that
it
(its
paper are intermediaries capital constrained, which
The paper by Besanko and Kanatas (1993)
in.
investigates the choice of financing
is
and monitoring intensity
also
in
an
equilibrium model like ours. However, collateral plays no role in their model. Intermediary
capital is plentiful
and the firms finance part of their investment from uninformed capital
in
order not to be monitored too carefully by intermediaries.
The next
projects.
section describes the basic model,
The equilibrium of
this
model with variable investment
that
model
size, in
is
analyzed
which features fixed sized investment
in section 3. Section
order to avoid
some of
are discussed to illustrate
its
to a
the technical complications
stem from fixed-size investment. The variable investment model
delivers preliminary answers to
4 moves on
is
highly tractable and
most of the questions raised above. Several variations of
versatility. Section 5
it
concludes with caveats and some future
research directions.
2
The
basic
model
The model has
two periods.
three types of agents: Firms, Intermediaries and Investors. There are
In the first period financial contracts are signed
In the second period investment returns are realized
neutral and protected
by limited
liability
and investment decisions made.
and claims
settled. All parties are risk
so that no one can end up with a negative cash
position.
2.1
The
There
difference
real sector
is
a continuum of firms. All firms have access to the
among them
is
that they start out with different
same technology;
amounts of
the only
capital, generically
we
denoted A. For simplicity,
assume
will
that all initial capital is cash;
more
generally,
it
could be any type of asset that can be pledged as collateral with second period market value
A.
2
The
distribution of assets across
firms
described by the cumulative distribution
is
function G(A), indicating the fraction of firms with assets less than A.
of firm capital
K =
is
f
j
AdG(A).
one economically viable project or
In the basic version of the model, each firm has
idea.
A
It
costs
I
in external
>
(in
period
1) to
undertake a project. If
may
We
R
(failure) or
Firms are run by entrepreneurs, who
benefit.
A <
I,
a firm needs
at least I
-
funds to be able to invest. In period 2, 'the investment generates a verifiable,
financial return equalling either
monitoring
The aggregate amount
(success).
in the
absence of proper incentives or outside
deliberately reduce the probability of success in order to enjoy a private
formalize this moral hazard problem by assuming that the entrepreneur can
privately choose between three versions of the project as described in Figure
Good
Project
1.
Bad
Bad
(low private
(high private
benefit)
benefit)
b
B
Pl
Pl
Private benefit
Probability of success
Ph
Figure
We
assume
that
Ap
Furthermore,
the
in the relevant
good project
is
= P H -P L
>
•
range of the rate of return on investor capital, denoted 7, only
economically viable, that
p H R - 7I
(1)
2
1
>
is,
>
p L R - 7I + B.
be uncertain, with an expected value equal to A. This
would not affect the analysis as long as the value of collateral is uncorrected with the project
The value of
outcome.
collateral could
We introduce two
rich
levels of shirking (two
way of modelling monitoring
bad projects)
in order to
have a
(see later). Private benefits are ordered
sufficiently
B >
b
>
and
can, of course, alternatively be interpreted as opportunity costs from managing the project
Note
diligently.
that either level
of shirking produces the same probability of success. This
has the convenient implication that the entrepreneur will prefer the high private benefit
project (B-project) over the
low private benefit project
(b-project) irrespectively of the
financial contract.
The
2.2
The
is
to
takes
financial sector
financial sector consists of
many
intermediaries.
The
function of intermediaries
monitor firms and thereby alleviate the moral hazard problem. In practice monitoring
many
forms: inspection of a firm's potential cash flow,
its
management, and so on. Often monitoring merely amounts
balance sheet position,
its
verifying that the firm
to
conforms with contractual covenants of the financial contract, such as a minimum solvency
ratio or a
common
minimum
cash balance. In the case of bank lending, covenants are particularly
and extensive. The intent of covenants
being diligent. With that in mind,
we assume
is
to
reduce the firm's opportunity cost of
that the
monitor can prevent a firm from
undertaking the B-project. This reduces the firm's opportunity cost of being diligent from
B
to b.
A
key element
in
our story
is
the assumption that monitoring is privately costly; the
intermediary will have to pay a non-verifiable amount c
>
in
order to eliminate the B-
project. Thus, intermediaries also face a potential moral hazard problem.
that
While we assume
each intermediary has the physical capacity to monitor an arbitrary number of
moral hazard problem puts a limit on the actual amount of monitoring
firm.., die
that will take place.
Moral hazard forces intermediaries
to inject
some of
their
own
capital in the firms that they
monitor, making the aggregate amount of intermediary (or "informed") capital,
K,,,,
one of
the important constraints on aggregate investment.
It
turns out that the exact distribution of assets
we assume
that all projects financed
among
intermediaries
ignore
to
integer
problems).
have an incentive
intermediaries
3
practice,
In
to
choose them
so,
Nevertheless, assuming perfect correlation
we know
need
up any
to put
discussion).
that without
capital (see
is
or because
obviously unrealistic.
some degree of
While perfect correlation
is
because
correlated
monitoring requires
macroeconomic shocks.
We make this assumption
correlation, intermediaries
Diamond (1984) and
that the
of a project (allowing
may be
projects
specialized expertise in a given market or instrument, or because of
only because
irrelevant if
by an intermediary are perfecdy correlated and
capital of each intermediary is sufficiently large relative to the scale
us
is
would not
the concluding section for further
an extreme case,
it
greatly simplifies the analysis.
Investors
2.3
Individual investors are small.
demand an expected
given (there
3
will often refer to
them from intermediaries, who
to distinguish
investors
We
is
One way
as
uninformed investors,
invest in firms that they monitor.
y*
rate of return
them
We
sometimes assume
that
y
is
Uninformed
exogenously
an infinite supply of outside investment opportunities that return 7) and
model perfect correlation is to let 9, distributed uniformly on [0,1],
represent an intermediary specific random disturbance, such that if 9 < p L all the
intermediary's projects succeed, if 9 > p H all of its projects fail and if Pl < 9 < p H its
projects succeed if and only if they are good. With this formulation, one can let the 9's vary
to
,
,
,
arbitrarily across intermediaries without affecting the analysis.
4
So, the uninformed will in equilibrium
demand nominal return 7/p H in case of si.ctcss
demand return /3/Dh in case of
for each dollar they invest. Similarly intermediaries will
success,
where
(5
is
the expected rate of return on intermediary capital.
sometimes
that the aggregate
amount of uninformed
capital invested in firms
is
determined
by a standard, increasing supply function S(7).
We
assume
firms cannot monitor other firms, perhaps because they have
that
insufficient capital to
be credible monitors (see
later)
or because they do not have the
informational expertise. Therefore, firms with excess capital will have to invest their surplus
cash
in the
open market, earning the uninformed
3
Fixed investment scale
3.1
Direct finance
We
that
is,
start
by analyzing the
rate of return 7.
possibility of financing a project without intermediation,
by using direct finance. Consider a firm
investors, treated here as a single party.
invest and
how much
it
A
that
borrows only from uninformed
contract specifies
have the following simple structure:
funds A, while the uninformed investors put up the balance
if
the investment fails;
investors are paid
Ru >
0,
(iii) if
(1),
A;
I -
It is
easy to see
the firm invests
(ii)
neither party
R >
f
all its
is
paid
and the
where
t
K„
=
K.
a necessary condition for direct finance
is
that the firm prefers to
diligent:
p HR f
>
p LR f
+
B.
Direct finance, therefore, requires that the firm be paid at least:
(IC f)
(i)
the project succeeds, the firm is paid
Kf
Given
each side should
should be paid as a function of the project outcome.
that an optimal contract will
anything
how much
R
f
> JL
Ap
.
be
This leaves
income
at
most R^
that can
= R
-
B/Ap
to
compensate investors, so the
maximum
be promised investors without destroying the firm's incentives,
pledgeable expected income,
is
p H [R
-
expected
call
it
the
B/Ap]. The pledgeable expected income cannot be less
than 7[TA], the market value of the funds supplied by the uninformed investors. Therefore
a necessary and sufficient condition for the firm to have access to direct finance
p„[R—
<
7 [I-A]
is:
]•
Defining
A(7) =
(2)
we
conclude that only firms with
In principle
We
capital.
A >
I-^[R~1.
A( 7 ) can
A( 7 ) could be negative,
rule out this uninteresting case
invest using direct finance.
which case firms could invest without own
in
by assuming
that the external opportunities for
investors are such that
pH R
(3)
Condition
(3)
simply states that the
-
7I < P H B/Ap.
from a project
total surplus
share a firm must be paid to behave diligently.
To
is less
the surplus
back
to investors is
by investing
its
own
be unable to invest, because they do not have the means
It
is
minimum
get external financing, therefore, total
surplus must be redistributed. But given limited liability, the only
some of
than the
way
a firm can transfer
capital. Capital
poor firms
will
to redistribute surplus.
follows that in this model, as in most models with liquidity constraints, efficiency
not defined by total surplus maximization. Therefore, while
it is
true that aggregate surplus
(and investment) could be increased by reallocating funds from uninformed investors to firms
that
are
capital
constrained,
externalities in this
model
such
transfers
that the firm
are
not
Pareto
improving.
There are no
and the investor cannot internalize as effectively as
8
a social planner facing the same informational constraints.
3.2
Indirect Finance.
An
intermediary can help a capital constrained firm to invest. Monitoring reduces the
firm's opportunity cost of being diligent (by eliminating the high benefit B-project), allowing
more
Some
external capital to be raised.
intermediary
itself
of the external funds will be provided by the
and some by outside investors. Thus,
in the case
of indirect finance, there
are three parties to the financial contract: the firm, the intermediary and the uninformed
investors.
It is
easy to see that an optimal three-party contract takes a form analogous to the
two-party contract discussed earlier: In case the project
the project succeeds, the payoff
R
f
R,,,
no one
is
paid anything; in case
divided up so that
is
R + Ru +
where
fails,
R,,,
R
denotes the intermediary's share and
f
=
and
R,
R u denote
the firm's and the investors'
shares as before.
Suppose the intermediary monitors. Since monitoring eliminates the high benefit
project (the B-project), the firm
benefit project (the b-project).
is
The
left to
choose between the good project and the low
firm's incentive constraint
is
now:
[Ap]R >b.
(IC f)
f
We may
assume
that
[Ap]Rf
<
B, else the firm would behave without monitoring.
In order for the intermediary to monitor,
[Ap]R m >c.
(ICJ
The two
incentive constraints (IC f) and
(ICJ imply minimum
returns for the fin.i and
the intermediary,
maximum
respectively.
The pledgeable expected income, again defined
the
expected income that can be promised to uninformed investors without destroying
incentives,
is
then
P„[R-^].
(4)
Ap
Note
that condition
(ICJ implies
that PhR,,,
-
c
>
0, so monitors earn a positive net
return in the second period. Competition will reduce this surplus
contribute to the firm's investment in the
the intermediary invests in a firm that
is
as
first
by forcing monitors
amount of
period. Let L^ be the
The
rate of return
to
capital that
on intermediary
capital
must exceed y. Consequently, firms prefer uninformed
capital
it
monitors.
then:
PH R m
8-
Since monitoring
to
is
costly,
/3
"informed capital". However, the incentive constraint (IQJ requires that the intermediary
be paid
at least
Rm =
c/Ap, implying that
i
to
each firm that
minimum
it
level of
m0
m 3)
will contribute at least
it
-
_5£_
(Ap)jS
firms that are monitored will
monitors. In fact,
all
informed
More would be
capital.
demand
excessively costly and less would be
inconsistent with proper incentives for the monitor. Note, however, that
it is
put into the firm that provides the intermediary an incentive to monitor.
provided by the return
Rm The
.
on the intermediary's capital so
take
I
m or
/?
as
precisely this
not the capital
The
incentive
is
required investment IJ^P) merely regulates the rate of return
that the
the equilibrating
market for informed capital clears.
variable,
monotone.)
10
since
(We
the relationship between
can either
the
tw
is
Uninformed investors must supply the balance
amount
is
positive.
A
Iu
=
A
I -
- In.03),
assuming
that this
necessary and sufficient condition for a firm to be financed therefore
is:
7[I-A-Im (/3)]
We
can rewrite
to
a > ttoA
-
firm with less than A(7,/3) in
supply enough capital for the project.
capital?
]'
condition as:
this
®
A
P„[R~
<
That does not work
initial assets
cannot convince uninformed investors
What about demanding more
than 1^/3) in informed
because for each additional dollar of informed capital,
either,
income
the pledgeable expected
i-w-^[R-^i-
be reduced by 0. Since
will
/3
exceeds 7, the
of capital that the firm can raise does not increase. This just restates that
firm to
demand
It
expect,
it
the
minimum amount of informed
the monitoring rate of return
>
j3
has to
increases. If for
is
its
-
c
= 7 I m (g) =
=
Ph7/Pl
11
optimal for a
and 7. As one would
market rate of return 7 or
demand
make
it
interest rates A(7,/3)
for monitoring.
would earn a
7PHc/([Ap]g),
>
7-
The
the intermediary prefer
determined by the condition:
translates into:
S.
to
open market, where
(3 is
/3
some combination of
must be high enough
rate of return
p Hc/Ap
which
/3
capital in the
The minimum acceptable
either the
too high and there will be no
come down. However,
monitoring to investing
7.
/3
A(7), the price of monitoring
rate
when
difficult to get financing
amount
capital.
follows from (4) and (5) that A(y,/3) increases in both
becomes more
it is
total
rate of return
If
>
A(7,£)
A(7), there
no demand for informed capital even
is
acceptable to the monitor; the monitoring technology
Naturally,
we want
to rule out this case.
met for a small enough
since
c,
little
B >
b.
lowest rate of return
too costly to be socially useful.
is
algebra yields the following necessary and
be socially valuable: cAp
sufficient condition for monitoring to
is
A
at the
<
p H [B-b]. This condition
5
Certification vs Intermediation
3.3
The preceeding
demand
analysis
that firms fall into three categories according to their
At one extreme are the well-capitalized firms with
for informed capital.
These firms can finance
shows
and demand no informed
their investment directly
other extreme are the poorly-capitalized firms with
at all. In
between,
we have
firms with A(y,/3)
A <
< A <
A(7,/3).
A >
capital.
A(y).
At the
These firms cannot invest
A(7). These firms can invest, but
only with the help of monitoring.
The
typical firm in the monitoring category finances
informed and uninformed
As we have described
capital.
6
We
5
If
b+c<B,
They
in
one of two ways.
the uninformed are independent
invest directly in the firm, but only after the
monitoring would allow a firm to raise more uninformed capital than
without monitoring; see
if
investment with a mixture of
can interpret mixed financing
the investment process so far,
investors as illustrated in Figure 2.
its
(4).
Therefore, there would be an equilibrium with monitoring even
own capital. Since intermediaries earn a positive profit in that
we have assumed that there is no constraint on how many firms an
intermediaries possessed no
case,
and since
intermediary can technically monitor,
such an equilibrium would feature rationing of
intermediaries analogous to rationing in efficiency
wage models. However, with any amount
of intermediary capital, those without capital could not be active. For the benefit of section
4,
we assume
6
that
b+c>B,
If there are firms for
demand informed
capital.
ruling out intermediation without capital.
which
They
A <
A(7), but
A +
I m (j3)
>
I,
will invest their excess funds in the
capital.
12
these firms will uniy
market for uninformed
monitor has taken a large enough financial interest that the investors can be assured that the
firm will behave diligently. In this interpretation, the monitor resembles a venture capitalist,
a lead investment bank, or more generally any sophisticated investor whose stake in the
borrower
certifies that the
borrower
investors for additional capital.
7
A
is
sound, allowing the firm to go to less informed
example
related
is
that
of a bank providing a loan
guarantee, or originating a securitized loan.
Monitors
Project
13
is
A{f,0)
not funded
"Indirect
as a
which invests
their
One can check
model views the monitor
et al
There
is
(1990),
as an intermediary such
this interpretation investors deposit their
money, along with
its
own,
that the optimal, incentive
in firms that
it
will
money with
the bank,
monitor (see Figure
3).
compatible intermediary arrangement (with the
unrealistic, but important proviso that all the
7
finance"
2: Certification
alternative interpretation of our
commercial bank. In
"Direct
*r)
finance"
Figure
An
Investors
monitored projects are perfectly correlated; see
a large literature on certification by venture capitalists; see, for instance, I>jTy
Megginson and Weiss (1991) and references
therein.
For evidence
that the the
participation of sophisticated investors can substantially enhance the ability to attract external
capital, see
Emerick and White (1992).
13
our concluding remarks),
is
equivalent to the certification arrangement
The amount of uninformed
much
equity
uninformed
it
capital that an intermediary can attract will
described.
8
depend on how
has as well as on the rates of return in the market for informed and
capital.
The intermediation case makes
clear that investors will
bound on the
intermediaries meet solvency conditions that put a lower
to total capital.
we have
For reasons of
variable investment
model
tractability,
we
ratio
demand
that
of their equity
will only analyze solvency conditions in the
(section 4).
Investors
Monitors
fi
Project
is
"Indirect
Ah,P)
Figure
"Direct
finance"
finance"
not funded
3.4
A{i)
Intermediation
3:
Equilibrium in the credit market
Since each firm will
demand
minimum amount of informed
the
capital ^(/S), the
intermediation can always duplicate the outcome of certification, which consists of
writing an isolated contract for each funded project.
could not do
strictly better
One may wonder whether intermediation
than certification by "cross-pledging" the returns on the various
projects that the intermediary funds. That this
is
not the case can be seen from the optimal
contract under intermediation. Because of perfect correlation if one project fails and another
succeeds,
it
must be the
case that the intermediary did not monitor the former. Because
harshest punishments are always optimal
when a
deviation
is
detected, the intermediary
then receive 0. This implies that the optimal strategy for the intermediary
all
projects
or monitor none,
and
that
is
.r.ust
either to monitor
therefore intermediation does not improve on
certification.
14
aggregate demand for informed capital will be
Assuming
that there is
9
of return
(3,
no excess supply of informed capital
Km =D m (7,0)
A(7,j6)
is
for informed capital
increasing in
for informed capital.
/?.
The
both A(7) and A(7,/3) and
demand
at the
is
decreasing in
Therefore, for each 7, there
it
G(A(7,/3))]Im(/3).
minimum
/3
acceptable rate
satisfies:
= [G(A-(7 ))-G(A(7,/3))]I m (/3).
Dm
effect of
-
7 on
Dm
is
because ^(jS)
/3,
is
a unique
/3
ambiguous, however.
then depends on the distribution function
is
decreasing and
that clears the
market
A
higher
G
whether aggregate
7
increases
increases or decreases with 7.
Equation
uninformed
is
[G(A(7))
an equilibrium in the monitoring market obtains when
(6)
The demand
Dm (7,/3) =
is
imperfectly
(6) fully describes the equilibrium if the rate
exogenous. If 7
elastic,
D
(7)
is
endogenous, that
is, if
of return 7 demanded by the
the uninformed supply of capital S(7)
one must add an equilibrium condition for uninformed
u (7,/3)
Aw [I-A-I
m 03)]dG(A)+[!
=
f
Ja(7.»
capital. Let
[I-A]dG(A)
Jaw
denote the demand for uninformed capital. The demand
D u is decreasing
in 7:
On one
hand,
firms with assets just above A(7,/3) are squeezed out by an increase in 7; on the other hand,
firms with assets just above
A (7) move
from direct
to indirect finance,
uninformed capital (since L^
>
By
has an ambiguous effect on
contrast, an increase in
effects.
Both effects reduce the demand for uninformed
Du
,
less
capital.
because there are two opposing
Firms with assets just above A(7,/3) drop out, which reduces the demand for
uninformed
Tlie
/3
0).
which uses
capital,
while firms relying on intermediation,
less interesting case
now demand more uninformed
of excess informed capital has (6) satisfied with an
ineq'..<mty,
is characterized by 7l m = p H Rm-c (intermediaries are indifferent between acting as
monitors and lending as uninformed investors), or equivalently by /3p L = 7p H
and
15
capital, since intermediaries
The market
for
have
to invest less per firm (JJfi) decreases with
uninformed
/?).
when
capital clears
D U (7,/3) = S(7).
(8)
For each
/?,
there
a unique 7 that solves
is
10
(8).
Instead of using (6) and (8) to determine
/?
following condition, obtained by substituting (6) into
(9)
Equation
total
(9) equates the firms'
can replace (8) with the
(8):
Km
(I-A)dG(A) = S( 7 ) +
'
f
we
and 7,
.
aggregate demand for capital (the
left
hand
supply of external capital. Note that this equation presumes that firms for which
A >
Changes
Our main
in the
supply of capital
interest is with the effects that
changes
have on the equilibrium outcome. Unfortunately, the
limits
what we can say about the behavior of
assumption that the investment size
demands and makes
is
fixed,
the distribution function
in asset values
fact that neither
interest rates.
D
u
nor
attention to the behavior of A(7,jS), the
The reader
familiar with
minimum
Yanelle's
critical role.
in individual firm
Rather than trying
intermediary's ability
is
we
to
will restrict
level of assets that a firm has to
have
in
might be concerned that an
deposits, and having obtained a
(1989) analysis
intermediary could raise deposit rates enough to attract
monopoly, control the
model with perfect
D m is monotone,
The problem stems from our
which creates discontinuities
G(A) play a
and capital supply
circumvent these problems by introducing specific assumptions about G,
capital
^ +
invest their excess funds in the market for uninformed capital.
I,
3.5
10
side) with the
all
on loans. However, Yanelle, who uses Diamond's (1?S4)
diversification, rules out agency problems. In our mode', ihe
to attract deposits is limited by its own capital. As long as informed
interest rates
not too concentrated, each intermediary will take
16
(3
and 7 as approximately given.
order to be able to invest.
variant of the
We
model
The next
section will look at the behavior of interest rates in a
that is analytically
more
tractable.
consider three types of capital tightening, corresponding to the three forms of
capital in the model. In a credit
crunch the supply of intermediary capital
a collateral squeeze aggregate firm capital
K =
f
\
AdG(A)
is
Y^
is
reduced; moreover,
that the reduction affects firms in proportion to their assets. In
reduced. In
we assume
a savings squeeze the savings
function shifts inward.
Proposition
1. In either
type of capital squeeze, aggregate investment will go
and A(7,/3) will increase. Consequently, poorly capitalized firms will be the
first to
down
lose their
financing in a capital squeeze.
Proof. If all capital were supplied inelastically, this result would be immediate, since
more
a firm with
check
always do as well as a firm with fewer
assets.
The one
detail to
by an increase
in
Suppose, hypothetically, that A(7,/3) goes down with any kind of capital squeeze.
A
is
that a reduction in firm or intermediary capital is not offset
uninformed
.
assets can
reduction in
capital.
A
is
the
same
as an increase in aggregate investment. Since an increase in
investment must be funded by uninformed capital, S would have to go up (see
an increase
in the interest rate y.
As uninformed
capital
implying
becomes more expensive, fewer
firms have access to direct finance; A(y) goes up as seen from (2). With
increased,
(9)),
A
reduced and
A
intermediation spans a strictly larger set of firms. Each firm must therefore
receive less informed capital
(^
decreases; see (6)), implying that
/3 is
pushed up. But since
informed and uninformed capital both have become more expensive, A(y,j8) cannot go r*own
(see (5)), contradicting the initial hypothesis.
17
Q.E.D.
Note
that Proposition
up when there
But
we
is
1
implies that at least one of the interest rates,
a capital squeeze. If both went down, (5) would imply that
or y, must go
A
goes down.
cannot rule out the possibility that one of the two interest rates increases. For
instance, in a credit crunch, as
level,
/3
implying a decrease
Of course,
if
in
A
and
it
all
/3;
uninformed capital
is
A move
up,
could be pushed above
Im
original
its
depends on the shape of the distribution function G.
supplied inelastically, so that
y
is
exogenous, then
must
/?
increase. In the other cases, similar ambiguities about interest rate effects can arise.
Another corollary of Proposition
model must be unique.
would have
to
all
poor firms lose
on
all
that the equilibrium in the fixed investment
is
were two different
be the same for both. But then
would be higher
Since
If there
1
in
one of the
A
forms of capital tightening result
three fronts.
While simple,
this
be
conclusion
1
shows
must also be the same, else both
equilibria, which, as
their financing, the effect will
equilibria, Proposition
we just
in the
all
is
noted,
is
/?
and 7
when
that capital
the tightening occurs
quite robust, which
is
reassuring given
The
the strong empirical evidence that small firms bear the brunt of a capital squeeze.
conclusion
to
is
assume
that both
Proposition
is, in
reinforced by considering changes in
1, it is
capital
R
the
in
or in p H
In a recession,
.
it is
natural
and p H decrease as well. Following the logic of the proof of
easy to see that either change will again cause an increase in A(y,/3), that
poor firms being squeezed out
One may argue
economies
R
A
impossible.
same outcome, namely
the stronger
that
that in the real
first.
world small firms are abandoned because of scale
monitoring. In a credit crunch, banks will have to sort out the good risks from
bad and small firms will not be worth the fixed cost of getting informed.
our model does not seem
effect as just described.
A
to
have scale economies. But
large firm that
is
in fact
it
does, with
On
the surface,
much
the
c
ame
monitored has to pay the same absolute amount
18
for monitoring as a small firm, so per unit of net worth,
monitoring costs do decrease with
which
is
the relevant measure here,
size.
Variable investment scale
4.
For
the remainder of the paper
investment
in
We
capital.
switch to a model with a variable level of
order to avoid the problem with discontinuities in individual
assume
are proportional to
monitoring
we
is c(I)
that investments
I
=
can be undertaken
=
(the private benefits are B(I)
cl
investment technology
at
any scale
constant returns to scale.
The
is
for
All benefits and costs
BI, respectively b(I)
and the return from a successful investment
is
I.
demand
R(I)
=
bl, the cost
=
RI). Thus, the
of
probabilities of success remain as
before equal to p H or p L depending on the firm's action.
4.1
The
firm's
Given the
program
rates of return
overall level of investment
Iu
I, its
/3
and 7, a firm
own
that holds initial assets
capital contribution
A
and the variables
to solve
Program
A
:
Maximize
U(A
=
)
p H RI
-
p^
-
PhR u
subject to
(i)
A < A
,
(ii)
A +
+
(iii)
PhR,,,
(iv)
p H Ru
I
m
>
>
Iu
>
I,
/3I m)
yl u
,
19
+ t(A
Aq
-A)
will
R
f,
choose
R,,,,
R
u,
its
Im ,
(v)
R» >
(vi)
R >
(vii)
R + R m + Ru <
In setting
an intermediary.
program
bl/Ap,
f
f
up the program
We
in
R.
we
way,
in this
will return to
Divide through
yields a
cI/Ap,
are assuming that
it is
that this is indeed the case in equilibrium.
check
equations in Program Aq by the firm's level of assets
all
which
all
choice variables are scaled by Ao and
all
independent of Ao. Consequently, an optimal solution takes the form:
R^Aq, and so on, where the variables with a
tilde
The firm
the parameters are
R = RA
f
same optimal policy
evident from our previous discussion that in equilibrium
will invest all
its
be paid just enough
to invest to the point
f
assets;
to
it
have an incentive
where
its
investment, substitute equalities
all
=
1.
=
In
constraints will bind.
to monitor; the intermediary will
return on capital
A
(i)
+ I[
and
P£]
its
own
(iii) - (vii)
+
j3Ap
(ID
R,,,
be paid just enough to be diligent; the intermediary
will
maximizes the leverage and return on
We
,
scaled by their
is /?;
assets.
into
lP»[R 7
I(Ao) -
-J^-rr
A,(7,j8)
20
(ii)
To
Ap
,
is:
find the
to get:
££] >
see that the highest sustainable level of investment
be required
and the investors will invest
I.
to the
way
the firm
maximum
level of
point where the pledgeable expected return equals the market return 7. This
(10)
This
This feature gready simplifies the aggregate analysis.
It is
will
A^
on top solve the program with Aq
other words, firms with different levels of assets use the
assets.
employ
desirable to
where the denominator
A l(7 ,/J)
(12)
represents the
amount of firm
Clearly, A,(y,/3)
is
<
1,
=
capital
1
|£
/3Ap
-
^[R-^£]
-
needed to undertake an investment of unit size (1=1).
reflecting the fact that the firm can lever
A,(7,j3), the higher the leverage. In equilibrium,
Ai(7,|S)
>
Ap
7
would want
0, else the firm
its
rates of return
own
capital; the
lower
must also be such
that
without limit.
to invest
Substituting equalities (i)-(vii) into the objective function gives the firm's
maximum
payoff:
(13)
The
U(AJ
net value of leverage to the firm
=
ffi-
is:
Ph d
<
"
L(Ap)A,(7,/3)
^
A
14 >
Assuming
monitoring
that
is
7]A
"
,
.
valuable, the term in brackets
is positive.
11
It
represents the
difference between the internal and the external rate of return on firm capital.
As
models with
rate, in
of return exceeds the market
liquidity constraints, the internal rate
case, because a dollar inside the firm
is
worth the market rate plus the incentive
most
our
effect.
Equilibrium in the capital markets
4.2
Because firms choose the same optimal policy per unit of own
is
in
easily found
"It
is
by aggregating across firms. Let
K
f
capital,
an equilibrium
be the aggregate amount of firm
capital,
easy to give a condition for monitoring to be of value. If a firm tried to finance
investment without monitoring, the optimal solution would be the same as with monitoring,
but with the substitutions c
=
and b
=
B.
evaluated at the lowest acceptable rate of return
will
be preferred
exogenous,
this
to
direct
condition
j3
Comparing monitoring to no monitoring,
= & (= Ph7/Pl)> one finds that moniioung
finance whenever c(p H 7-pL)/Ap
is satisfied
for small
21
enough
c.
<
(B-b)/B.
Taking 7 as
K,,,
the aggregate
capital.
The
uninformed
first
amount of informed
two are
capital
(the
capital
and K„ the aggregate supply of uninformed
fixed, while the third, K„, is determined so that the
sum of
the
pledgeable expected returns
= 7(KJ
discounted by 7) equals the supply S(7). Let 7
p H (K f +
The implied
Km
rates of return in the
+
K U)[R
two markets
PhKP
7 =
(16)
J^]
-
be the inverse supply function. The
=
tCKJK,
are:
-
gl
K.
Ph cK
=
(17)
where
K = K +
f
K,,,
+ Ku
is
the total
(Ap)K m
amount of
capital invested.
l(K»)K u
fS[R-(b + c)/Ap]K%
I<„
Figure 4
for
of individual firms,
equilibrium in the market for uninformed capital obtains when:
(15)
demand
Figure 4 provides a graph of
in
order for investment to be
the pledgeable expected
finite,
how K„
is
determined.
the equilibrium value of
income p H [R-(b+c)/Ap] (per
As can be
seen from Figure 4,
y must be such
that
it
exceeds
unit of investment).
Equations (16) and (17) show that the equilibrium rates of return on firm and
intermediary capital depend in the obvious
way on
the relative scarcity of these
two forms
of capital. However, equation (15) shows that the aggregate level of investment only depends
on the sum of firm and intermediary
capital.
This
is
a consequence of our assumption that
firm and intermediary capital are in fixed supply; only uninformed capital responds to
changes
in the rate
of return. If firms had more than one type of investment opportunity, the
optimal choice would generally depend on the relative costs of capital and, consequently,
overall investment
sensitive to the relative supplies of firm
and intermediary
4.4 will illustrate a variation on this theme.
capital. Section
Changes
4.3
would be
in the
supply of capital
In addition to analyzing the effect that changes in the supply of capital have on
interest rates
and investment,
we
will also consider the effect these
changes have on the
solvency ratios of firms and intermediaries. Each firm's solvency ratio equals the aggregate
solvency
is
ratio,
which
defined by rm
=
is
defined by rf
KJ^+KJ.
= K/K.
Likewise, an intermediary's solvency ratio
12
Proposition 2:
A.
A
K,,,
(credit crunch)
decreases y
(ii)
Here we are adopting the interpretation
that
(i)
12
decrease in
intermediary.
23
increases
investors
/3
invest
in
firms
via
an
(iii)
A
B.
decreases
(iii)
increases rm
decrease
7
in v (savings
(i)
increases
(iii)
increases rm
(ii)
decreases
(iv)
decreases rf
(ii)
decreases
(iv)
increases rf
j8
squeeze)
7
In all cases investment (K)
These
increases rf
(iv)
decrease in JQ {collateral squeeze)
(i)
A
C.
decreases rm
and the supply of uninformed capital (KJ decline.
results follow directly
from (15)
-
(17).
To
illustrate, in
a credit crunch,
intermediary capital contracts, less uninformed capital can be attracted, lowering
Dividing (15) through by
K
goes down. The contraction
in
u
shows
in
that
K^K^
and 7.
must decrease, since K/Ku increases and 7
uninformed capital
is less
than proportional to the contraction
Consequently, informed capital will be relatively scarcer than before, which increases
K,,,.
/3
and lowers
rf
of firms will increase.
rm .
Since both informed and uninformed capital contracts, the solvency ratio
How does this stack up with the Scandinavian experience? A
all
Ku
when
recession, of course, hits
our capital variables as well as some of the parameters, such as the probability of success
(Ph) or the payoff R, so
hand,
if reality
the
overextended and had
It
may be imprudent
to
compare the
results with reality.
looked very different from our simple predictions,
Arguably,
13
it
Scandinavian recession
to reign in
started
as
it
would be
a credit crunch.
On
the other
disquieting.
Banks were
on lending. 13 The gap between lending and deposit
rates
appears that the Scandinavian credit crunches were a consequence of the deregulation
of credit markets, which
have been implicated
in
caused them to over-heat and then collapse. Regulatory reforms
other credit crunches as well. For example, the big 1966 ..redit
first
24
widened
at this stage,
which
is in line
with the increase in
/3
and decrease
in y. Overall
investment dropped by more than the reduction in bank lending as banks forced firms to
consolidate their battered balance sheets (improve solvency); this
A
collateral.
is
related empirical counterpart to rf is the leverage provided
We know of no systematic evidence,
consistent with
by a
dollar's
A
(iv).
worth of
but anecdotal reports indicate that at the hight
of the 80's boom, a dollar of collateral brought in about a dollar and a half of loans.
Currently, that ratio averages seventy cents per dollar of collateral. Again, this
A
with
is
consistent
(iv).
The solvency of the banks dropped dramatically and recovered only with government
support and a monetary ease. Even though rm should go
down according
to
A
(iii),
this result
cannot be directly matched with the evidence, since regulatory rules clearly governed the
behavior of banks. Nevertheless, our analysis
about the regulation of capital
so,
ratios.
Should these
how? Our model provides one reason why
In a recession, intermediaries will
capital,
because interest
rates,
may have some bearing on
ratios
capital
the on-going debate
vary with the business cycle and
adequacy
ratios should
if
be pro-cyclical.
have the right incentives with a lower share of own
and hence contingent payoffs, are higher.
14
Needless to say, there are numerous aspects to consider. Our model gives no reason
for regulating solvency ratios of intermediaries, since the market will provide the proper
level of discipline. Indeed, if
one adds solvency constraints
crunch in the U.S. started when ceilings on
to the
model, the aggregate
level
CD rates were imposed (see Wojnilower (1966)).
1990 reclassification of many private placements, from investment grade
to speculative grade, produced a sharp decrease in lending by life insurance companies. In
199 1 gross insurance holdings of non-financial corporations below investment grade, fell by
53 percent (while those of investment grade fell by 6 percent; see Carey et al (1993)).
More
recently, the
,
14
to
In an unconventional interpretation
of government subsidies one can see them as a way
permit counter-cyclical solvency ratios.
25
of investment and welfare will go down
if
the constraints bind. But if
one views government
as a representative of investors, as in Dewatripont and Tirole (1993), then our results
on
solvency ratios could be interpreted normatively.
Incidentally,
our dual interpretation of monitoring
dilemma with regulating
The market equilibrium
capital adequacy.
rather
illustrates
is
the
nicely one
same whether
investors invest directly into firms (certification) or indirectly (intermediation). In the former
case, the monitor offers an implicit guarantee to the investors, while in the latter case the
guarantee
is
more
explicit (there is a contract
—
between the
parties).
do not care about which form the guarantee
is
the crucial point
is
whether the monitor holds a sufficient contingent
The
investors
—
and
this
takes. All they care about
interest in the project.
Solvency
ratios
alone do not capture the effective guarantee provided. Indeed, the solvency ratio of a certifier
that
does not intermediate
is
by definition equal
to 1, but that is
no assurance for proper
monitoring.
4.4
Endogenous monitoring
So
far
we have
kept monitoring intensity fixed.
monitoring intensity should vary
levels of capital.
There
is
in
The
logic of the
model suggests
that
response to changes in aggregate as well as individual
an obvious
way
to
model varying monitoring
intensity: let the
opportunity cost b be a continuous rather than discrete variable. In accordance with our
earlier interpretation
alternate
of monitoring, one can imagine that the firm has a continuum of
bad projects, distinguished by differing levels of private benefit
the intensity level c eliminates
where
all
b.
Monitoring
at
bad projects with a private benefit higher than b(c), say,
c represents the cost of monitoring
and b(c) the functional relationship beU'^n
monitoring intensity and the firm's opportunity cost for being diligent.
26
With
this apparatus, let us first revisit the fixed
firms that were monitored
monitor had
to
to
be paid a
demanded
minimum
reduce the intensity of monitoring,
Any
A >
firm for which
b implies a lower
and with
it
the
c.
same amount of informed
the
return.
all
investment model. In that model
It is
capital,
all
because the
evident, however, that if firms could choose
but the most poorly capitalized firms would do so.
A(y,/3) can reduce
its
cost of capital
by
letting
b increase.
A higher
This relaxes the intermediary's incentive compatibility constraint (ICJ
amount
that the intermediary has
intermediary has to invest,
In,.
The firm
to
be paid, P^, and the amount the
replaces the loss in intermediary capital with cheaper
uninformed capital for a net gain.
In this variation, the relationship
firm assets
is
between the intensity of monitoring and the
continuously rather than discretely declining.
implies that the intensity of monitoring
is
More
positively related to the
level of
interestingly, the
amount of
model
capital that the
intermediary has to put up. Intermediaries that monitor more intensively are required to have
a higher solvency ratio. This seems consistent with casual evidence. Commercial banks do
not monitor very intensively, which partly explains
extensively.
By
contrast venture capitalists hold a
finance, because their participation in overseeing
In
the variable investment model,
intensity (because the choice of
b
in
all
why
they can leverage their capital so
much
larger stake in the projects they
management
is
much more
firms are monitored at the
Program Aq,
is
intense.
same
level of
independent of Aq). However, the level
of intensity varies with the aggregate amounts of intermediary and firm capital. Using (11)-
(13),
we
see that the firm will choose b to minimize A,(7,/?)/b, the
unit of private benefit.
to
an increase
the response
is
in
/3
It is
assets per
immediate, by revealed preference, that b increases in response
(keeping y exogenous). Therefore,
to shift
amount of own
towards
when informed
less intensive monitoring.
27
capital gets sc?-cer,
Conversely, when informed capital
gets
more abundant
that
it
be harnessed
The
relative to firm capital, the
to
most
efficient use
of informed capital requires
monitor more intensively.
between
substitutability
own
capital
and
monitoring,
and
the
attendant
requirements for intermediary capital, allows some additional reflections on the Scandinavian
crisis. In the past year, the
commercial banks have largely recovered from the
capital
and are again looking for profitable investment opportunities. The main problem
many
firms are
still
now
crunch
is that
seriously short of collateral and therefore have a hard time qualifying
Banks are blamed for being overly cautious, which seems understandable given the
for loans.
more information
intensive
financing, basing lending partly on cash flows rather than just balance sheets. This
is in line
recent events. But they have also indicated an intent to shift to
with the prediction that monitoring should intensify as the relative amount of intermediary
capital grows.
When
is
endogenous, aggregate investment will depend not just on the
15
firm and monitoring capital as in (15), but also on the relative amounts of each.
sum of
15
monitoring
Another variation
in
which aggregate investment will depend on the
is worth brief mention.
relative
amounts
of firm and intermediary capital
Suppose
that investment
is
continuous, but subject to decreasing returns to scale. Let
R(I) denote a firm's gross profit in case of success, with R'
=
For given expected
0.
the expected net profit,
08-7)1.
U(I)
is
,
or:
>0, R" <0, R'(0) =
<», R'(°°)
and 7, a firm's net utility U(I) is still equal
p H R(I)-7l, minus the extra cost of using intermediary capital,
rates
of return
U(I) = p H R(I) - T I -
]S
C^pM^)
to
1-
maximized at some investment I*. A firm's utility therefore depends on its asset level
its borrowing capacity. The latter is obtained by replacing "RI" by "R(I)" in
only through
the derivation of equation (11). Incentive compatibility for the firm requires that I<I(Ao)
where I(A
) is
given by:
™>-;|-£ -^)
(I
The investment
assets
A
capacity I(Ao)
such that I(Aq)>
is
I*
I
- A )1=bI
°
'
an increasing and concave function of assets Aq. Firms with
bunch
at
investment level
constrained.
28
I*
while the others are credit
In particular, an extra dollar of informed capital will
expand investment by more than an
extra dollar of firm capital, because an increase in monitoring capital leads to
more
intensive
monitoring, which in turn allows firms to increase their leverage (without a change in
monitoring, (15)
us that the transfer
tells
transferring a dollar
from investors
would have no investment
to intermediaries
effect).
As
before,
would not be Pareto improving. But
a government preoccupied with the level of economic activity, this suggests a reason
may be more
efficient to subsidize intermediaries than to subsidize firms.
second reason
is that,
unlike in our model, the government typically has
which firms are worthy of support.
Using intermediation
utilizes
little
for
why
it
(Of course, a
knowledge of
information
more
effectively.)
Concluding remarks
5.
We have offered this analysis as a first step towards
understanding the role played by
the distribution of capital across differently informed sources of capital. In our
borrowing capacity of both firms and intermediaries
is
model the
limited so that a redistribution of
wealth across firms and intermediaries impacts investment, monitoring, and interest rates.
All types of capital tightening
-
hit
— a credit crunch,
a collateral squeeze, and a savings squeeze
-
poorly capitalized firms the hardest, and, as Proposition 2 shows, each such shock has
In this version, the investment-over-assets multiplier is a decreasing function of assets,
that is, firms with
evident
that
the
more
assets will
distribution
have a higher solvency
of capital across
firms,
as
ratio r f
well
.
as
For this reason, it is
between firms and
intermediaries, influences aggregate investment, unlike in the constant returns to scale case
be more adversely affect^ by
a reduction in intermediary capital depends on the shape of R(I). There are two conflicting
effects: lower leverage makes large firms less sensitive, while lower marginal returns make
analyzed
in section 4.1.
them more sensitive
Whether firms with more
to a rise in
/3.
29
capital will
a distinguishable impact on interest rates, monitoring intensity, the solvency of intermediaries
and the firms' leverage.
The models we have worked with
are simple and the exercises
we have been
through
should be seen as experiments with prototype models that will be useful for coming efforts
understand
to
how
information and ideas get matched through a financial network featuring
different levels and kinds of expertise, and
monetary shocks. The
fact that
is
facts
encouraging. Also, the general methodology
tractable.
We have been
careful not to get ahead of ourselves
too primitive for that. Nevertheless,
it is
on policy matters; the models are
legitimate to let pilot studies suggest
for thinking about policy issues. In this regard,
ratios
such a financial network reacts to real or
our models are able to reproduce some of the stylized
associated with the Scandinavian debt crisis
seems quite
how
we
new avenues
find the logic behind pro-cyclical solvency
of interest for the regulatory debate. As well, the fact that monitoring intensity will
respond positively
to increases in
intermediary capital, lends some support to the market
interventions undertaken in Scandinavia.
In a desire to get a first cut at the relative shifts in capital
monitoring and investment,
out
some
In
we have made
its
several unpalatable assumptions.
implications for
We wish to point
limitations of our modelling that deserve attention.
our analysis
we have
taken the supply of firm and intermediary capital as
exogenous and performed comparative
A
and
statics exercises
on each one of them independently.
proper investigation of the transmission mechanism of real and monetary shocks must take
into account the feedback
dynamic model,
from
for instance,
interest rates to capital values.
This will require an explicitly
along the lines of Kiyotaki-Moore (1993). Preliminary
investigations suggest that this route
is
interesting
30
and
tractable.
To keep
enable us
matters simple,
we have
identify alternative
to
stayed
away from modelling
features that
forms of monitoring with standard
institutions.
To
intermediary could be a bank, an equity holder, a venture capitalist, etc.
wants to explain the emergence of and evaluate the relative role of these
to bring
in other ingredients
However,
analysis, organizational refinements
of
institutions,
this
Our
the extent one
(presumably control related considerations)
macroeconomic
for a
would
one has
the model.
in
kind
may
not be
important.
Another caveat concerns our assumption that the intermediary's projects are perfectly
As we explained,
correlated.
there
is
nothing realistic about this assumption;
of avoiding the extreme (and equally unrealistic) conclusion that
carried out without
own
capital.
We
all
it is
just a
way
intermediation can be
see the issue of diversification, the degree of leverage
and the intensity of monitoring as closely linked, complementary choice variables
that
deserve more careful study in the future.
Our
final,
make sense only
and most important caveat concerns the role of
in
most agency models
may have more
is
that the
capital. It
seems
to
an entrepreneurial model. But most intermediaries (including firms) are
of course not run by entrepreneurs. So
that
own
in finance suffer
because
bite,
how
we
is
one
to interpret this
from the same
criticism,
are highlighting the role of
manager and the owners of
own
though here the critique
capital.
One
interpretation
ties that for
~
not a very convincing story,
why new
capital providers cannot join
be treated as a single entrepreneur
and logically hollow
it
leaves open the question
First, let us note
formed such close
the intermediary have
practical purposes they can
in that
model?
this close-knit
team, obviating the need for external funds. Another interpretation, and the
one we favor,
is
that
management enjoys a continuing stream of
our analysis was normalized to zero for convenience), that
31
is
private benefits (whi^h
in
proportional to the assets under
his
management. Thus, committing
incentive consequences
which leads
to
much
somewhat
assets to a project in
like in the original
model.
which they may get
We
have explored
lost has
this variation,
different expressions for incentive compatibility, necessary levels
of assets and so on, but the fundamental insights and the character of the analysis do not
change. Yet,
will require a
it
is
evident that a fuller understanding of
much
In closing,
how
intermediaries allocate capital,
richer managerial model.
we emphasize
the broader research agenda associated with the introduction
of scarce loanable funds. Limited intermediary capital
of credit crunches and cyclical solvency
ratios.
But
it
is
a necessary ingredient
also ought to
to the study
be the key
to a better
understanding of other issues such as the propagation of monetary policy through the banking
system. Accordingly,
we hope
that future theoretical research will put greater
loanable funds.
32
emphasis on
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34
See ^<y^
^?-
Date Due
031S9S
AUG.
3
MAY
1
18»
26
OCT
SEP 3
8 1938
1JI99
\