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Banks as Better Monitors and Firms' Financing Choices in Dynamic General Equilibrium


  • Solomon, Bernard-Daniel


This paper builds a dynamic general equilibrium model that emphasizes banks' comparative advantage in monitoring financial distress in order to explain firms' choice between bank loans and market debt. Banks can deal with financial distress more cheaply than bond holders, but this requires a higher initial expenditure proportional to the loan size. In contrast, bond issues may involve a small fixed cost. Entrepreneurs' choice of bank or bond financing depends on their net worth. The steady state of the model can explain why smaller firms tend to use more bank financing and why bank financing is more prevalent in Europe than in the US. A higher fixed cost of issuing market debt is a key factor in replicating the higher use of bank financing relative to market debt in Europe. Finally, we find that for plausible calibrations one can predict aggregate quantities just as well using a model with only one type of loan with costs of financial distress that are an average of the costs for bank loans and market debt.

Suggested Citation

  • Solomon, Bernard-Daniel, 2008. "Banks as Better Monitors and Firms' Financing Choices in Dynamic General Equilibrium," MPRA Paper 23958, University Library of Munich, Germany, revised 01 Jun 2010.
  • Handle: RePEc:pra:mprapa:23958

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    References listed on IDEAS

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    More about this item


    financial frictions; costly state verification; financial distress;

    JEL classification:

    • G3 - Financial Economics - - Corporate Finance and Governance
    • E4 - Macroeconomics and Monetary Economics - - Money and Interest Rates


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