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Optimal banking with delegated monitoring

Author

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  • Antic, Nemanja
  • Hu, Tai-Wei

Abstract

We propose a model of financial intermediation based on delegated monitoring, where firms' returns are private information that lenders can ascertain through costly state verification. Our model has two key features: lenders cannot commit to their verification strategies and there are aggregate shocks. Simple debt contracts are Pareto optimal with or without intermediation. We show that the benefits of intermediation can be limited by financial instability in the presence of aggregate shocks. However, a well-designed resolution mechanism ensures the Pareto optimality of financial intermediation, and a bail-out policy can restore financial stability.

Suggested Citation

  • Antic, Nemanja & Hu, Tai-Wei, 2024. "Optimal banking with delegated monitoring," Journal of Economic Theory, Elsevier, vol. 222(C).
    • Handle: RePEc:eee:jetheo:v:222:y:2024:i:c:s0022053124001108
    DOI: 10.1016/j.jet.2024.105904
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    More about this item

    Keywords

    Banking regulations; Costly state verification; Delegated monitoring;
    All these keywords.

    JEL classification:

    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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