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Allowing for Risk Choices in Diamond's "Financial Intermediation as Delegated Monitoring"

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  • Hellwig, Martin

    (Sonderforschungsbereich 504)

Abstract

The paper studies the relative efficiency of intermediated finance and direct finance in a variant of Diamond's (1984) model of ''financial intermediation as delegated monitoring''. Project sizes are taken to be variable so a choice must be taken on whether to fund a small number of projects on large scale or a large number of projects on a small scale. In the absence of effective advance commitments to lending policies, this introduces an additional agency problem of intermediated finance as the well known excessive-risk-taking effect of debt finance induce intermediaries to underdiversify. The paper analyses the impact of this effect on the performance of intermediated finance under various assumptions about project technologies. Most strikingly, in the case of fixed monitoring costs and project technologies with stochastic constant returns to scale, there is no diversification at all, and intermediated finance is worse than direct finance. In this very case, with effective advance commitments to lending policies, an optimal intermediation arrangement would exploit both, the scope for diversification and the scale effects in monitoring so as to attain approximately first-best outcomes when there are many available projects.

Suggested Citation

  • Hellwig, Martin, 1998. "Allowing for Risk Choices in Diamond's "Financial Intermediation as Delegated Monitoring"," Sonderforschungsbereich 504 Publications 98-04, Sonderforschungsbereich 504, Universität Mannheim;Sonderforschungsbereich 504, University of Mannheim.
    • Handle: RePEc:xrs:sfbmaa:98-04
    Note: It is a pleasure to acknowlegde helpful discussions with Vittoria Cerasi, Christian Laux, and Paul Povel. Financial support from the Deutsche Forschungsgemeinschaft is gratefully acknowledged.
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    Cited by:

    1. Sonja Daltung & Vittoria Cerasi, 2006. "Financial structure, managerial compensation and monitoring," FMG Discussion Papers dp576, Financial Markets Group.
    2. Fabio Di Vittorio & Delong Li & Hanlei Yun, 2018. "On Bank Consolidation in a Currency Union," IMF Working Papers 2018/092, International Monetary Fund.
    3. Carletti, Elena & Cerasi, Vittoria & Daltung, Sonja, 2007. "Multiple-bank lending: Diversification and free-riding in monitoring," Journal of Financial Intermediation, Elsevier, vol. 16(3), pages 425-451, July.
    4. Cerasi, Vittoria & Daltung, Sonja, 2006. "Financial structure, managerial compensation and monitoring," LSE Research Online Documents on Economics 24634, London School of Economics and Political Science, LSE Library.
    5. Urs W. Birchler, 2000. "Are banks excessively monitored?," Working Papers 00.14, Swiss National Bank, Study Center Gerzensee.
    6. Hellwig, Martin, 1998. "On the Economics and Politics of Corporate Finance and Corporate Control," Sonderforschungsbereich 504 Publications 98-43, Sonderforschungsbereich 504, Universität Mannheim;Sonderforschungsbereich 504, University of Mannheim.
    7. Gianni De Nicolo, 2000. "Size, charter value and risk in banking: an international perspective," International Finance Discussion Papers 689, Board of Governors of the Federal Reserve System (U.S.).
    8. Bertrand Rime, 2007. "Could Regional and Cantonal Banks Reduce Credit Risk through National Diversification?," Swiss Journal of Economics and Statistics (SJES), Swiss Society of Economics and Statistics (SSES), vol. 143(I), pages 49-65, March.
    9. Alex Stomper, 2006. "A Theory of Banks' Industry Expertise, Market Power, and Credit Risk," Management Science, INFORMS, vol. 52(10), pages 1618-1633, October.

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