Survey_CCD_2004

Abstract

Consider a two-date economy (T = 0, 1) with three classes of risk neutral agents: numerous firms, banks and investors. Firms have access to an investment project each, and need external funds to finance them. Only bank lending is available, and banks can decide either to finance firms on their own ?individual-bank lending? or to share lending with other banks ?multiple-bank lending. Projects are risky and their returns are i.i.d. across firms. Each project i requires 1 unit of indivisible investment at date 0, and yields a return Xi = {0, R} at date 1. The success probability of each project i, pi = Pr{Xi = R}, depends on the behavior of its entrepreneur. It is pH if he behaves well, and pL if he misbehaves, with pH > pL. Misbehavior renders entrepreneurs a non-transferable private benefit B, which can be thought of as a quiet life, managerial perks, and diversion of corporate revenues for private use. There is a moral hazard problem because entrepreneurs’ behavioral choices are not observable. Banks have E units of capital each and raise D units of deposits (henceforth, also debt) from dispersed investors. Firms receive financing only if banks expect nonnegative profits, i.e., if they expect a return at least equal to the gross proceeds y ? 1 from an alternative investment. Suppose now that banks can ameliorate firms’ moral hazard problem through monitoring. Each bank j chooses to monitor project i with an intensity mij ? [0, 1], which determines the probability with which it observes firm i’s behavior and improves it in the case of misbehavior. Monitoring is costly, an intensity mij costs C(mij ) = c 2m2ij . The convex cost function reflects the greater difficulty for a bank to find out more and more about a firm, and it means diseconomies of scale in monitoring. The size of the monitoring costs is determined by the parameter c (henceforth, also referred to as cost of monitoring). Banks’ monitoring intensities are not observable either to investors or to other banks. This introduces another moral hazard problem in the model, and it implies that banks can raise deposits only if they can credibly promise investors an expected return at least equal to the proceeds y from the alternative investment. The timing of the model is as follows. At the beginning of date 0 banks choose between individual-bank lending and multiple-bank lending, their choice is observable to both investors and other banks. Then, each bank offers investors a deposit contract specifying the per-unit deposit rate. If investors accept the contract, each bank j chooses the intensity mij with which to monitor project i. At date 1 project returns are realized and claims are settled. Figure 1 summarizes the timing of the model if investors accept the deposit contracts.