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Why Banks?

Microeconomic Foundations of Financial Intermediaries


Ilonka Rühle

In the banking literature the existence of financial intermediaries is generally explained in terms of the transformation of risks, terms and lot-sizes. Yet these functions could also be performed by system of perfect and complete markets. Therefore, the approach taken in Why Banks? is to start by investigating the conditions that, in the real world, render markets imperfect and incomplete, namely asymmetric information distribution and uncertainty. Incentive compatible financing instruments (standard debt contracts as well as equity participation) provide a means of solving these problems. Financial intermediaries ultimately owe their existence to their ability to save transaction costs using these instruments and to solve problems relating to the enforcement of contracts.


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Contents List of Tables and Charts The ,Development and Finance" Series Foreword Acknowledgements INTRODUCTION 1 INFORMATION PRODUCTION MODELS 1.1 The Information Problem: Adverse Selection as a v IX X XIV XV 10 Consequence of Hidden Characteristics 10 1.2 The Solution Without Financial Intermediaries 12 1.2.1 Separating Equilibria with Signals 12 1.2.2 The Existence of Separating Equilibria 16 1.2.3 Separating Equilibria in Cases Involving Multiple Signals 18 1.3 The Solution With Financial Intermediaries 20 1.3.1 The Role of Financial Intermediaries 20 1.3.2 Ensuring the Reliability of the Information Produced 23 1. 3. 2. 1 Direct Sale of Information 23 Indirect Sale of Information 27 1.3.3 Appropriability of Returns 31 The Grassman/Stiglitz Information Paradox 31 "Delays" and "Distortions" as a Source of the Appropriability of Returns 33 1.3.4 Direct versus Indirect Information Transfer 37 Direct versus Indirect Sale of Information 37 Direct versus Indirect Acquisition of Information 41 1.4 Conclusion 44 VI Contents 2 DELEGATION MODELS 46 2.1 The Information Problem: Moral Hazard Due to Unobservable Actions or Returns 46 2.2 The Solution Without Financial Intermediaries 48 2.2.1 The Design of Financial Contracts 48 2.2.2 Equity Participation and Standard Debt Contract as Instruments for Solving Problems of Selection, Monitoring and Control 2.3 The Solution With Financial Intermediaries 2.3.1 The Roles of Financial Intermediaries 2.3.2 The Delegation of Search and Selection to Financial 54 64 64 Intermediaries 69 2.3.3 The Delegation of Monitoring to Financial Intermediaries 75 2.4 Direct versus Intermediated Financing Relationships 80 2.4.1 Reducing Delegation Costs...

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