DP2909 | Risk and Intermediation in a Dual Financial Market Model

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This Paper investigates the relationship between risk and productive activity and the degree of financial intermediation in a model with moral hazard. Entreprenuers can simultaneously get credit from two types of competing institutions: ?financial intermediaries? and ?local lenders?. The former are competitive firms with a comparative advantage in diversifying credit risks, and the latter have superior information about the investment returns of a ?nearby? entrepreneur. This information advantage allows local lenders to save on intermediation costs that are otherwise related to lending activity. By diversifying risks, financial intermediaries are able to offer a safe asset to local lenders and, because of intermediation costs, the latter are willing to diversify their portfolio by offering some direct lending to the nearby entrepreneur (incomplete insurance). We show that, in some cases, a fall in intermediation costs, by inducing local lenders to choose a safer portfolio, reduces entrepreneurs? effort and increases the probability of default.