Consider an economy with one consumption goods and one input. The consump-tion goods can be produced by a number of risky producconsump-tion technologies.
Entrepreneurs
There are a continuum type of entrepreneurs (also called firms) with different skill levels of managing risky production technologies, denoted by e; e is distributed over the interval [e, ¯e] with a distribution function n ˙f(e) where n is the mass of entrepreneurs and R[e, ¯e] f(e)de = 1. The type of the entrepreneur is private infor-mation and can be observed by commercial banks when they applying the costly screening technology. A firm does not have any unit of the input, but has access to risky production projects with different levels of productivity, indexed by S. A production project with productivity S requires an investment of one unit of the input to produce S units of the output with probability P(S, e), and zero otherwise.
The probability function P(S, e) satisfies the following conditions:
Assumption 1 Ps< 0, Pss ≤ 0, Pe> 0, and Pse> 0.
A higher skill level of management indicates a higher probability of success in production. For entrepreneurs there is a trade-off between productivity and risk.
The choice of a higher productive project leads to a higher possibility of failure.
Here is an example satisfying Assumption 1:
P(S, e) = 1 −AS
e , where A > 0, and S ∈ [0, ¯e/A]. (1)
To simplify the analysis and keep the tractability, we use this example to derive our analysis.
We assume that entrepreneurs are risk neutral and maximize their expected profits by choosing where to borrow funds and what type of projects to adopt.
They borrow funds either through security markets by issuing securities or through loan markets by going to a commercial bank to apply a loan. When a firm chooses to issue securities, it needs go to an investment bank to underwrite its securities.
We assume that a firm can arrange its fund sources with only one financial insti-tutions to rule out the possibility of syndicate loans and mixtures of direct and indirect finance.
Agents
There are identical agents (also called households). The population of these iden-tical agents is m. Each agent has one unit of input and has access to only the risk free technology which uses one unit of input to produce RF units of output. The agents are risk averse and have a strictly concave and differentiable utility func-tion u(C). An agent chooses to allocate its endowed unit of input either to the risky free technology or lend it to entrepreneurs who have access to risky assets.
We assume all lending activities have to go through either banks or financial mar-kets. We assume that private information makes it too costly for agents to have financial transaction directly with entrepreneurs. Thus there is no possibility of pairwise meetings between agents and entrepreneurs.
Financial Institutions1
Assume that there are two types of financial institutions, commercial banks and investment banks (hereafter called underwriters). Banks obtain funds by taking in deposits from agents and paying depositors interests at a gross rate RD. After receiving a firm’s application for a loan, a bank applies its screening technology to uncover the type of the firm at a cost of c units of the input goods and to verify the type of its proposed production project. The screening outcome is observable only to the bank, not to all other financial institutes and the public investors. The bank may and may not approve the loan application. If it approves the application, the bank also decides an (gross) interest rate (RL) it will charge for the loan. Since the screening technology yields exact information for the type of the applicant, the loan rates is contingent on the type of firms e.
An investment house underwrites securities for firms in exchange of fee in-comes. An investment bank delivers to the public investors the information they find out in the process of underwriting. Due to information asymmetry the pub-lic investor is not sure that the delivered information is complete and perfect. In reality, how convincing the information is depends upon many factors such as in-vestment projects, the reputation of the firm that raises funds, and the efforts of underwriters. In particular, the more efforts an underwriter put in collecting, an-alyzing and deliver data, the more convincing the information is. However, the
1The description of financial institutions mainly repeat what described in the report of the first year research with some changes to make the description relevant to this general equilibrium model.
information processing is costly. The efficiency of information processing tech-nology used by underwriters also matters. How much profit an investment bank can obtain for a underwriting case depends upon all these factors. In this paper we do not get into the details of this aspect. Instead, we assume that underwriting business is quite competitive and, thus, the underwriting fee (φ) an investment bank can collect from its clients is determined by market competition. We model the performance of underwriting process by a parameter of convincing power (de-noted by θ). More specifically, we assume that the public investor understands that the probability of success P(S, e) depends on who runs what kind of produc-tion technology; however they just do not know what (S, e) is. They make their investment decisions basing upon their belief P(S, e) on P(S, e). We use˜ θ to de-scribe how close the belief of the public to the real P(S, e): P(S, e) =˜ θP(S, e), 0<θ < 1.
Nowadays it is quite common to observe the mixture of direct and indirect lending for an investment project. As shown in Bolton and Freixas (2000) an equilibrium model with a mixture of bonds- and loans-financed capital structure can be very fruitful but paying a cost of analysis complexity. The purpose of this paper is to show that how competition from markets affects the risk structure dis-cussed in banking literature. It is natural to start with a simple analytical structure and get a clear-cut picture. Only after this step we can go with more confidence to set up a more complicated framework to tackle more difficult issue.
The Gramm-Leach-Bliley Act lifted the ban of securities operation for
com-mercial banks. Like universal banks in Europe, comcom-mercial banks in the US started to integrate both loans and securities business under the Act. In many economies, for example Taiwan, Korea and Japan, the integration of financial sec-tor is also under way. Financial holding companies (or universal banks) become a popular form of financial organization. Economies of scale are the driving force behind this trend. The border line between banks-financed and markets-financed funds become burring. Both loans and securities issuing are substitutes and plements of each other and, Obviously, universal banks and financial holding com-panies play an important role in such a financial environment. However. for sim-plicity, we do not include financial holding companies and universal banks in our analysis. We concentrate on the substitution role of both direct and indirect lend-ing and leave the complement role as our future research topic.