A Dilution Cost Approach to Financial Intermediation and Securities Markets

Abstract

This paper proposes a model of financial markets and corporate finance, with asymmetric information and no taxes, where equity issues, Bank debt and Bond financing may all co-exist in equilibrium. The paper emphasizes the relationship Banking aspect of financial intermediation: firms turn to banks as a source of investment mainly because banks are good at helping them through times of financial distress. The debt restructuring service that banks may offer, however, is costly. Therefore, the firms which do not expect to be financially distressed prefer to obtain a cheaper market source of funding through bond or equity issues. This explains why bank lending and bond financing may co-exist in equilibrium. The reason why firms or banks also issue equity in our model is simply to avoid bankruptcy. Banks have the additional motive that they need to satisfy minimum capital adequacy requeriments. Several types of equilibria are possible, one of which has all the main characteristics of a "credit crunch". This multiplicity implies that the channels of monetary policy may depend on the type of equilibrium that prevails, leading sometimes to support a "credit view" and other times the classical "money view".