A smoke screen theory of financial intermediation

Abstract

This paper explores the role of diversification and size in protecting information. We present a simple two period credit market with a sophisticated lender faced with competitors who free ride on his screening activity. Absent commitment problems, the lender funds one borrower and exerts optimal evaluation. When borrowers cannot commit to a long term relationship, the free riding problem is responsible for too little evaluation. We show how this problem can be mitigated by simultaneously financing several borrowers. This effect provides a rationale for intermediaries as an ‘information garbling’ device.

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