Financial Intermediation, Loanable Funds, and The Real Sector

TLDR: In this article, an incentive model of financial intermediation in which firms as well as intermediaries are capital constrained is studied, and how the distribution of wealth across firms, intermediaries, and uninformed investors affects investment, interest rates, and the intensity of monitoring.

Abstract: We study an incentive model of financial intermediation in which firms as well as intermediaries are capital constrained. We analyze how the distribution of wealth across firms, intermediaries, and uninformed investors affects investment, interest rates, and the intensity of monitoring. We show that all forms of capital tightening (a credit crunch, a collateral squeeze, or a savings squeeze) hit poorly capitalized firms the hardest, but that interest rate effects and the intensity of monitoring will depend on relative changes in the various components of capital. The predictions of the model are broadly consistent with the lending patterns observed during the recent financial crises. I. INTRODUCTION During the late 1980s and early 1990s several OECD countries appeared to be suffering from a credit crunch. Higher interest rates reduced cash flows and pushed down asset prices, weakening the balance sheets of firms. Loan losses and lower asset prices (particularly in real estate) ate significantly into the equity of the banking sector, causing banks to pull back on their lending and to increase interest rate spreads. The credit crunch hit small, collateral-poor firms the hardest. Larger firms were less affected as they could either renegotiate their loans or go directly to the commercial paper or bond markets. Scandinavia seems to have been most severely hit by the credit crunch. The banking sectors of Sweden, Norway, and Finland all had to be rescued by their governments at a very high