No. 111 - Delegated screening and reputation in a theory of financial intermediaries

Why do people lend to banks rather than to final borrowers? This paper provides a rationale for the preference to indirect lending (writing a deposit contract with a bank) over direct financing of individual entrepreneurs based on the presence of ex-ante asymmetric information. Ex-ante asymmetric information might create a "lemon" problem and therefore produce a need for screening, which in turn makes delegation profitable. The intermediary is then characterized as an agent performing a delegated screening role. However, delegation gives rise to a standard agency problem. This is solved, in a sequential context, by the incentives provided by reputation.