Benevolent Regulation, Delegated Monitoring and Loan Pricing in Financial Intermediation

This paper introduces benevolent agency and loan pricing in financial intermediation when a regulator uses capital as incentive and delegates monitoring to financial intermediaries who are better at screening, assessing risks and issuing loans to borrower firms. The model predicts three phenomena: [1] Multiple credit rationing equilibria that depend on the distribution of loan size and agency cost regimes; [2] An endogenous equilibrium loan pricing model (LPM) with portfolio separation in loan size, where risk-adjusted returns on securitized loans are linear in the agency cost aversion of lenders; [3] An endogenous mechanism - based on decision rules obtained from the mixture distribution of size portfolios - that breaks credit market failure when intermediaries over or under invest. We extend these results to provide a robust closed form expression for expected regulation costs associated with risk based capital requirements (RBCRs). Furthermore, we identify a regulator's dilemma in which intermediaries adopt dominant overinvestment strategies when there are no RBCRs. But contrary to extant literature, we find that at best intermediaries respond by weakly underinvesting when RBCRs are imposed. Moreover, we derive an optimal capital ratio for intermediaries and show that regulation has no effect on their investment decisions when loan spreads exceed RBCRs. A Monte Carlo experiment and semi- parametric kernel estimates are provided to demonstrate empirical predictions of the theory