This paper studies implications of intermediation costs in credit markets. The presence of intermediation costs increases the amount of risky projects therefore results in financial fragility. Moreover, for an open economy that has a perfectly liberal capital account, prudent firms finance their projects from foreign markets therefore shrinking the domestic credit markets. The theoretical predictions of our model gains support by Turkish data for the 1991 – 2004 period. Data suggests that an increase in intermediation costs results in an increase in non-performing loans, and an increase in foreign financing (shrinking of domestic credit markets). We argue that minimization of these costs improves financial soundness.
