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Why Banks?

Microeconomic Foundations of Financial Intermediaries

Series:

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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2. DELEGATION MODELS 46

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46 Delegation Models 2 Delegation Models 2.1 The Information Problem: Moral Hazard Due to Unobservable Actions or Returns In contrast to the models discussed in Chapter 1, where the analysis focused on the problems of adverse selection due to hidden characteris- tics, the present chapter analyzes the consequences of moral hazard. On the one hand, moral hazard is a product of the behavior of one or several parties to a contract and stems, as indicated in the introduction, from the asymmetric distribution of information between on the one hand a party which provides funding - henceforth referred to as the financier as long as it has not been specified what kind of financing contract is being used, and as the lender in the special case where a loan contract is the selected form of financing -and on the other hand, a party which acquires external funds. As external financing is mostly undertaken for the purpose of investing, the second party will, in the general case, be referred to as the investor or, in the special case of a loan, as the borrower. In order to facilitate the exposition, the financier (or lender) shall henceforth be designated by the female form and the investor (or borrower) by the male form. Intermediaries shall have the neutral form: Thus, she (the financier) provides funding to him (the investor); and in some cases it is advisable that it (an intermediary) interposes itself between her and him. Moral hazard can be the result of the...

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