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topic10_detailed_note - U NIVERSITY OF E SSEX D EPARTMENT...

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U NIVERSITY OF E SSEX D EPARTMENT OF E CONOMICS EC372 Economics of Bond and Derivatives Markets Financial Intermediation II: Loans versus Bonds Overview This note explores why capital is sometimes raised directly from wealth holders (e.g., private in- vestors) typically using the vehicle of marketable securities (such as bonds) and sometimes in- directly from wealth-holders via intermediaries (e.g., banks) typically as individually negotiated, non-marketable loans. Several possible explanations are available: here the focus is on the ‘dele- gated monitoring’ approach, in which some wealth-holders delegate to intermediaries the function of monitoring borrowers in order to determine the loan contracts offered to borrowers (some potential borrowers may be refused loans altogether). Section 1 outlines three approaches to delegated monitoring, and describes the motivation for one of these in more detail. Sections 2, 3 and 4 describe the models presented in Holmstrom, B. and Tirole, J. “Financial Intermediation, Loanable Funds, and the Real Sector”, Quarterly Journal of Economics , vol. 112, August 1997, pp. 663–691, abbreviated as ‘HT’. In particular, sections 2 and 3 present the core of this note – study these carefully. 1. Financial Intermediation as Delegated Monitoring In the ‘delegated monitoring’ approach investors (but not necessarily all investors) delegate re- sponsibility to an intermediary (e.g., a bank) to monitor the ultimate recipients (borrowers, e.g., firms) of investors’ funds. Such delegation could result from several causes, including: (i) economies of scale (intermediaries gather funds from investors and lend to many borrowers); (ii) expertise (inter- mediaries have a comparative advantage in specialist monitoring skills); (iii) ‘lumpy’ (indivisible) investment projects (each firm’s investment project may require the funds of many investors). There is a separate, and different, sense in which ‘monitoring’ is used in the context of financial intermediation, namely monitoring of the intermediary by – or on behalf of – investors who provide the intermediaries funds (e.g., depositors). Such monitoring is typically undertaken in the form of government regulation (e.g., requirement of banks to hold specified proportions of their assets as equity capital). This aspect of monitoring is not considered further here: instead the focus is on monitoring by banks. Freixas & Rochet 1 identify three aspects of ‘delegated monitoring’: Screening – the monitor’s function is to assess the creditworthiness of the borrower in order to determine whether to grant a loan with pre-specified contractual terms; the monitor does not exert any other form of control over the borrower. The model considered in the notes for ‘Financial Intermediation, I’ is of this sort.
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