Borrower and Lender Reputation Effects: A New Theory of Financial Intermediation.

This paper formulates a new theory of financial intermediation and explains the general structure of credit markets. Borrowers without established credit histories have incentives to repudiate their debt obligations, and are therefore unable to issue debt directly. Banks exist in order to provide finance for this class of borrowers. Banks can curtail borrowers' incentives to default on debt by building a reputation for liquidating defaulters. However, over time, borrowers' concerns about reputation improve their incentives, such that they are able to issue debt directly.