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On the Coexistence of Banks and Markets*


  • *

    We would like to thank Hendrik Ballhausen, Alexandrina Braack, Patrick Bolton, Dirk Hackbarth, Volker Hahn, Holgar Mueller, Massoud Mussavian, Eva Terberger-Stoy, a CentER referee, seminar participants at the London Business School and in Berlin, and the referees for their helpful comments. This research was supported by the Deutsche Forschungsgemeinschaft through the SFB 649 “Economic Risk”.


We examine the coexistence of banks and financial markets by studying a credit market where the qualities of investment projects are not observable and the investment decisions of entrepreneurs are not contractible. Standard banks can alleviate moral-hazard problems, while financial markets operated by investment banks can alleviate adverse-selection problems. In competition, standard banks are forced to increase repayments, since financial markets can attract the highest-quality borrowers. This, in turn, increases the share of shirkers and may make lending unprofitable for standard banks. The coexistence of financial markets and standard banks is socially inefficient. The same inefficiency may occur with the entrance of sophisticated banks, operating with a combination of rating and ongoing monitoring technologies.