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Moral hazard in financial markets Inefficient equilibria and monetary policies

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Author Info
FEDELE, Alessandro

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Abstract

This paper presents a moral hazard model of financing in which borrowers adopt two modes of finance, either issuing bonds or applying for bank loans. The bond rate is set by the borrowers, while the loan rate is chosen by a monopolisticbank. Bank finance ameliorates the moral hazard problem by monitoring borrowers. Monetary interventions, which affect real economy through the bank lending channel, are justified on the basis of welfare considerations. When theinformational problem is not severe, monitoring is wasteful and welfare is enhanced through a monetary tightening. When the moral hazard problem is severe, monitoring is useful and welfare is increased by a monetary expansion.

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Paper provided by Université catholique de Louvain, Center for Operations Research and Econometrics (CORE) in its series CORE Discussion Papers with number 2005019.

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Date of creation: 01 Feb 2005
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Handle: RePEc:cor:louvco:2005019

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Related research
Keywords: moral hazard; monitoring; monetary policies; bank lending channel;

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Find related papers by JEL classification:
D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information
E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy

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  1. James, Christopher, 1987. "Some evidence on the uniqueness of bank loans," Journal of Financial Economics, Elsevier, vol. 19(2), pages 217-235, December. [Downloadable!] (restricted)
  2. Gertler, Mark & Gilchrist, Simon, 1994. "Monetary Policy, Business Cycles, and the Behavior of Small Manufacturing Firms," The Quarterly Journal of Economics, MIT Press, vol. 109(2), pages 309-40, May. [Downloadable!] (restricted)
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  3. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Blackwell Publishing, vol. 51(3), pages 393-414, July. [Downloadable!] (restricted)
  4. Kashyap, Anil K & Stein, Jeremy C & Wilcox, David W, 1993. "Monetary Policy and Credit Conditions: Evidence from the Composition of External Finance," American Economic Review, American Economic Association, vol. 83(1), pages 78-98, March. [Downloadable!] (restricted)
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  5. Holmstrom, Bengt & Tirole, Jean, 1997. "Financial Intermediation, Loanable Funds, and the Real Sector," The Quarterly Journal of Economics, MIT Press, vol. 112(3), pages 663-91, August.
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  6. Bernanke, Ben S & Blinder, Alan S, 1988. "Credit, Money, and Aggregate Demand," American Economic Review, American Economic Association, vol. 78(2), pages 435-39, May. [Downloadable!] (restricted)
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  7. Jeremy C. Stein, 1998. "An Adverse-Selection Model of Bank Asset and Liability Management with Implications for the Transmission of Monetary Policy," RAND Journal of Economics, The RAND Corporation, vol. 29(3), pages 466-486, Autumn. [Downloadable!] (restricted)
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