Loanable Funds, Monitoring and Banking

This paper studies financial intermediation in a general equilibriumoverlapping generations model. Indivisible investment projects combine withinformational imperfections to create a (hidden action) moral hazard problemand introduce a role for third-party monitoring. Agency costs at theintermediary level are also considered. Under some conditions, monitors canbe viewed as banks facing a non-trivial portfolio diversification problem.Equilibria are derived in which a large nationwide bank coexists with anumber of community-regional banks, a structure of strong empiricalrelevance. Policies such as a mandatory reserve requirement are shown tohave substantial effects on the levels of investment in the economy.