| Abstract: | A financial institution that finances and monitors firms learnsprivate information about these firms. When the institutionseeks funds to meet its own liquidity needs, it faces adverseselection ("liquidity") costs that increase with the risk ofits claims on these firms. The institution can reduce its liquiditycosts by holding debt rather than equity. Conversely, exceptin a limited setting resembling venture capital, firms thatdepend on monitored finance prefer to give the monitoring institutiondebt rather than equity. Institutions with less frequent orless severe liquidity needs have greater appetite for equityand for the debt of more risky borrowers. These predictionsare consistent with general patterns of monitored finance. |
