Risk and Intermediation in a Dual Financial Market Economy

A model of the financial market is evaluated that consists of competing credit institutions (local lenders and financial intermediaries) to determine risk and intermediation effects on the financing obtained by entrepreneurs. Local lenders are considered to be principals with respect to the local entrepreneur by providing exclusive loan contracts, whereas financial intermediaries are considered price takers, who supply loans to local entrepreneurs imposing no quantity constraints, and collect deposits from local lenders. Local lenders are thought to be able to save on intermediation costs while financial intermediaries benefit from credit diversification. A simple model of a two-period, one-commodity economy with production is considered. Analysis of the model shows the intermediation costs (bookkeeping, enforcement, monitoring, or transportation) that financial intermediaries impose in their lending can lead entrepreneurs to seek financing from local lenders.Because of the moral hazard problem, entrepreneurs take on safer projects, and local lenders seek to diversify their portfolios and also take on safer projects. (SRD)