NEW YORK UNIVERSITY
STERN SCHOOL OF BUSINESS
POLICYMAKING IN FINANCIAL INSTITUTIONS Brian Gendreau
B40.3312.30 Spring 2001
NOTES ON DELEGATED MONITORING
I. Despite the inroads that securitization made on financial intermediation in the 1970s and 1980s, bank loans
remain an important source of business and consumer credit. As of September 27, 2000 there were $1.08
trillion in commercial and industrial loans outstanding at U.S. banks, and $1.63 trillion in bank real estate
loans outstanding. Even though many large corporations are able to borrow directly through the securities
markets, many of them still borrow from banks as well. .
A. Why do some firms issue debt directly in the markets, while others borrow exclusively from
B. Why do some firms do both?
II. In the past 15 years a new theory of the banking firm has arisen that is making progress toward answering
some of these questions. The theory focuses on:
A. Information asymmetries, which occur when one party to a transaction has more information
than the other;
B. The problems that arise from information asymmetries; and
C. The institutional arrangements that have been developed to solve — or at least ameliorate — t
Suppose information were complete and costless. Then we would probably not need banks. Issuers and
investors could find, negotiate, and transact with one another directly (possibly over the internet).
But: Information about borrowers is not costless to gather or analyze, and information in financial markets
is often incomplete. In particular, it is often prohibitively expensive for investors (who are outsiders to the
borrowing firm) to stay informed about developments inside the firm.
Illustration [from M. Berlin (1987)]: Suppose an investor wants to lend directly to a firm. He/she would
1. Find a firm that needs money;
2. Determine its credit standing;
3. Negotiate the terms of the loan (How much? For how long? At what interest rate?); and
4. Find some way to make sure that the firm’s insiders are not diverting resources to themselves
at his/her expense, or are not making business decisions that make the loan riskier. In other
words, the investor would have to monitor the firm, which could be difficult and costly.
III. What kind of contract would arise without monitoring? [Examples mostly from Diamond (1996)]
1. The firm needs to raise $1 million, henceforth referred to simply as $1;
2. Investors’ required rate of return is 5%;
3. Everyone aggress that the firm has a profitable project to finance;
4. Only the firm (the borrower) will be able to observe how profitable the project turns out to be.
In this case, think of a firm in a far-away locale that is borrowing from an individual investor. A conflict of
interest exists between the firm’s insiders, who can appropriate resources to themselves, and investors
(outsiders to the firm).
The project costs $1 to finance. The project has two possible outcomes:
1. High (H) — which can be thought of as occurring during good business conditions, with
probability of .8, in which it returns $1.4; and
2. Low (L) — which can be thought of as occurring during a recession, with probability of .2, in
which it returns $1.
How would an equity contract work in these circumstances? It would have to be some sort of profit sharing
arrangement. Let’s assume it takes the form of a promise on the part of the firm to pay a fraction ? of the
profits from the project to the investor.
Problem: The payoff to the firm and the investor are not portions of the project’s true value, V, but of the
value reported by the firm, Z. Therefore, the payoff to the firm is V- ?????With no monitoring, the value of Z that maximizes the payoff to the firm is zero. In other words, the firm has an incentive to report that the
project has turned out to have a low value — as low as zero.
So: Equity contracts do not work well — if at all — without monitoring.
Obviously, the investor would like to be able to put some kind of sanction on the firm when it appears it might be under-reporting the project’s value. Here we will assume:
1. The investor can force the firm into bankruptcy and seize and liquidate the assets of the firm;
2. But: Bankruptcy is expensive. So expensive, in fact, that the investor recovers only ? percent
of the value of the firm’s assets, where 0 < ??, 1. (D. Diamond assumes that ? = 0 — that the
bankruptcy consumes all of the firm’s assets, which is an extreme assumption, but one that
simplifies the example)
Therefore, the amount recovered by investors is: ?V
Bankruptcy costs are: (1-?)V.
The investor would like to set a face value on the loan, f, (principal + interest) that will (a) allow it to meet the required rate of return of 5%, and (b) will somehow induce the borrower to repay the loan if it can.
From now on we will now refer to the investor as the lender because the contract is a loan. Note that the
only tools available to the lender in the absence of monitoring are the power to force the firm into
bankruptcy, and the ability to set the face value of the loan.
With bankruptcy and liquidation now possible, the payoffs are:
Outcome: L (1-P = .2) H (P = .8)
V: $1 $1.4
Return to firm: 0 V – f
Return to lender: ?V f
How should the lender set f?
Expected return to lender = .8f + .2?V = $ 1.05 (the required rate of return);
Therefore: f = ($1.05 – .2?V)/.8
This will depend on the expected recovery rate on the assets in the event of a liquidation. The higher the
recovery rate, the lower the face value (and therefore interest rate) has to be on the loan. For the following
recovery rates the face value is:
Recovery rate, ? Face value of loan, f
The last case, where the recovery rate is zero and the contractual interest rate on the loan is 31.125%, is the
example given in the Diamond article.
For this loan contract to work, the lender must always put the firm into liquidation if any offer is made to repay less than the full face value of the loan — regardless of whether it thinks a bad outcome (L) has occurred or the borrowers are simply not being truthful. Look at the payoff structure to the transaction
above. The only way the borrower makes any money on the transaction is if the outcome is good (H) and
by being truthful (in which case it will get to keep an amount equal to V – f). This contract is incentive
compatible — it has provided the borrower with the incentive to repay the loan if it can.
What does this tell us about the kinds of contracts that will arise when monitoring is not possible?
1. They will be debt contracts with fixed face values;
2. Covenants of the debt contracts will be written tightly;
3. The debt contracts will be inflexible. If the covenants of the loan are violated the firm will be
placed into bankruptcy, period. No other factors will be taken into account.
IV. Loan contracts with monitoring.
Why don’t investors engage in monitoring?
1. If there a few large investors monitoring may make sense. But if there are many potential
investors, each with only a relatively small amount to invest, it is likely to be too costly, both
individually and collectively.
For example, suppose the firm wants to borrow $1 million and there are 10,000 investors,
each with $100 to invest. If the monitoring cost is $200, no one will monitor — too
2. There is a free rider problem. Why should an investor monitor (and incur the expense) when
he or she knows that someone else is monitoring.