Three essays on information, contracting, and financial intermediation

The body of this dissertation consists of three papers: Chapters Two, Three, and Four. The first of these analyzes direct financial contracting between the manger of a firm and investors when it is costly to verify firm output. First, an extension of Townsend\u27s (1979) result is obtained, enabling us to characterize optimal contracts when agents may be risk averse. Then it is shown that the use of the same contract for multiple identical investors is always dominated by asymmetric contracts in which some investors take subordinated positions involving more monitoring and higher returns in non-verified states. The model offers an explanation for the existence of multiple classes of securities even in the absence of taxes. Chapter Three examines an alternative mechanism for reducing the verification costs of multiple investors: the delegated monitoring model of Diamond (1984) and Williamson (1986). When delegated monitors ( banks ) are finite in size, perfect diversification is not possible, and bank capital is another means for reducing the cost of monitoring the monitor. We look at two regimes: monopoly and free entry. In the former case, the bank tends to exploit borrowers rather than depositors, which may cause a reduction in welfare compared with direct lending. With free entry, multiple equilibria are possible due to the presence of adoption externalities; at least one equilibrium will always exist whenever direct lending is feasible, and sometimes in situations where neither direct lending nor monopoly banking is possible. Chapter Four focuses on some general issues raised by the previous chapter. Most models of financial intermediaries involve some notion of economies of scale linked to increasing diversification. When competing institutions issue debt-like claims to investors and compete through rate , increases in market share help the investors but hurt profit margins. This creates adoption externalities, and investor beliefs are central to the determination of equilibrium. For plausible refinements of investor beliefs, intermediaries with low margins find it unprofitable to increase market share, leading to equilibria with multiple banks coexisting. We examine the affects this has on the possibility of collusion, free entry equilibrium, and policy choice by regulators