Financial Intermediation and Delegated Monitoring

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The Review of Economic Studies Ltd.

Financial Intermediation and Delegated Monitoring Author(s): Douglas W. Diamond Source: The Review of Economic Studies, Vol. 51, No. 3 (Jul., 1984), pp. 393-414 Published by: Oxford University Press Stable URL: http://www.jstor.org/stable/2297430 . Accessed: 03/09/2011 10:01 Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at . http://www.jstor.org/page/info/about/policies/terms.jsp JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org.

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Review of Economic Studies (1984) LI, 393-414 ? 1984 The Society for Economic Analysis Limited

0034-6527/84/00280393$02.00

Financial

and Intermediation

Delegated

Monitoring

DOUGLAS W. DIAMOND University of Chicago
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.

INTRODUCTION This paper develops a theory of financial intermediation based on minimum cost production of information useful for resolving incentive problems. An intermediary (such as a bank) is delegated the task of costly monitoring of loan contracts written with firms who borrow from it. It has a gross cost advantage in collecting this information because the alternative is either duplication of effort if each lender monitors directly, or a free-rider problem, in which case no lender monitors. Financial intermediation theories are generally based on some cost advantage for the intermediary. Schumpeter assigned such a "delegated monitoring" role to banks, ... the banker must not only know what the transaction is which he is asked to finance and how it is likely to turn out but he must also know the customer, his business and even his private habits, and get, by frequently "talking things over with him", a clear picture of the situation (Schumpeter (1939), p. 116). The information production task delegated to the intermediary gives rise to incentive problems for the intermediary; we can term these delegation costs. These are not generally analysed in existing intermediation theories, and in some cases one finds that the costs are so high that there is no net advantage in using an intermediary. Schumpeter made a similar point, although he did not consider incentives explicitly: ... traditions and standards may be absent to such a degree that practically anyone can drift into the banking business, find customers, and deal with them according to his own ideas.... This in itself... is sufficient to turn the history of capitalist evolution into a history of catastrophes (Schumpeter (1939), p. 116). This paper analyses the determinants of delegation costs, and develops a model in which a financial intermediary has a net cost advantage relative to direct lending and borrowing. Diversification within the intermediary is key to the possible net advantage of intermediation. This is because...
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