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THE ECONOMICS OF THE PRIVATE MARKET

Information-based Theories of Financial Intermediation

Some theories of financial intermediation focus on the information problems associated with financial contracting. Such theories emphasize that financial intermediaries enjoy economies of scale in producing information about borrower quality because of fixed costs of producing information about any given borrower. Fixed costs make having only one or a few lenders for each borrower economical. Many small individual investors can delegate information-production responsibility to a single large financial intermediary that alone bears the fixed costs. 84

Commercial banks and life insurance companies are financial intermediaries in the spirit of these models. Both types of institution collect funds from many relatively small investors. These investors (depositors or policyholders) delegate due diligence and monitoring responsibility to the intermediary.

  1. See, for example, Boyd and Prescott (1986), Diamond (1984), and Ramakrishnan and Thakor (1984).

The Covenant-Monitoring-Renegotiation Paradigm

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