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A smoke screen theory of financial intermediation

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  • Breton, R.

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.

Suggested Citation

  • Breton, R., 2011. "A smoke screen theory of financial intermediation," Working papers 356, Banque de France.
  • Handle: RePEc:bfr:banfra:356
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    Cited by:

    1. Tri Vi Dang & Gary Gorton & Bengt Holmström & Guillermo Ordoñez, 2017. "Banks as Secret Keepers," American Economic Review, American Economic Association, vol. 107(4), pages 1005-1029, April.

    More about this item

    Keywords

    financial intermediation; informational rent; asymmetric information; free riding; diversification.;

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • G00 - Financial Economics - - General - - - General
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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