Diamond, 1984, \"Financial Intermediation as Delegated Monitoring\": This paper

Question

Diamond, 1984, "Financial Intermediation as Delegated Monitoring": This paper develops a theory of financial intermediation based on minimum cost production of information useful for resolving incentive problems. An intermediary (such as a bank) is delegated the task of costly monitoring of loan contracts written with firms who borrow from it. It has a gross cost advantage in collecting this information because the alternative is either duplication of effort if each lender monitors directly, or a free-rider problem, in which case no lender monitors. Explain these arguments (the formal derivation of the model is not required here).

Explanation / Answer

Financial intermediaries (such as banks) can reduce the cost of monitoring, tracking and disseminating information. This means there is no duplication of effort required which has associated costs. The incentive problem is also solved as there is these intermediaries act as third parties and the appropriation of incentives is not an issue. Moreover, the free rider problem in case of money lending(the risk associated with people not repaying the loans) is also resolved due to enough information on consumer behaviour and credit history checks.

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