Intermediation and the equilibrium allocation of investment capital : Implications for economic development

We investigate several common assertions about intermediation and how it affects the allocation of investment capital. We use a model with adverse selection and costly state verification in which both debt contracts and credit rationing are observed. Intermediaries arise due to a comparative advantage in information acquisition. Relative to the situation absent intermediation, intermediaries reduce credit rationing and (inefficient) interest rate differentials. The model also shows how large interest rate differentials can be observed when financial markets are not integrated and how the volume of intermediation is affected by changes in the environment.