Content area
Full Text
Banks and other financial intermediaries are the main source of external funds to firms. Intermediaries provided more than 50 percent of external 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 important 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 of intermediaries. The cost of monitoring and enforcing debt contracts issued directly to investors (widely held- debt) is a reason that raising funds through an intermediary can be superior. Debt contracts include contracts issued to intermediaries by the borrowers that they fund (these are bank loans) and the contracts issued by intermediaries when they borrow from investors (these are bank deposits). Portfolio diversification within financial intermediaries is the financial-engineering technology that facilitates a bank's transformation of loans that need costly monitoring and enforcement into bank deposits that do not.
This article both simplifies and extends the analysis in Diamond (1984). Adding an assumption about the probability distribution of the returns of borrowers' projects makes the analysis simpler. There are a few new results that extend the analysis because this article drops the assumption that nonpecuniary penalties can be imposed...