The latest global financial crisis has provided abundant examples of a sudden breakdown of credit relationships when poorly informed investors revised their previously held views. The aggregate magnitude of the ensuing negative financing shock to real economic activity was big enough to make the financial crisis go over into a severe worldwide recession. Although, initially, only a minority of financial institutions was affected by adverse balance sheet developments, businesses seemed to have difficulty finding a replacement for their original lender when the latter became either distressed or overcautious. In an ideal (“Modigliani-Miller”) world of competitive and efficient financial intermediation often used as a convenient shortcut in macro models, there is no place for such effects. Although more recent DSGE-with-financial-frictions models assign a prominent position to the financial sector, they usually rely on a properly functioning financial intermediary as a propagator of real shocks. However, the latest global crisis, particularly the extent of credit decline at its peak, has uncovered a certain deficit of attention in macro modeling, to improperly functioning financial intermediaries as a shock source. The bulk of the existing macro literature is preoccupied with orderly market operation, conceding but a modest space to shortcomings, both on the capital provider and capital consumer sides.
On the other side, the theory of financial intermediation in its present state does not offer enough possibilities to compare relative strength of impact of its various phenomena of interest (such as agency, imperfect competition, institutional design, etc.) in a common setting relevant to macro theorists. Finally, asset pricing theory, once it has to depart from its well-fathomed Walrasian foundation, provides a lot of ambiguous messages about markets for producer liabilities, which are still to be integrated into the conventional macroeconomic paradigm.
All these problems could be alleviated if the workings of financial imperfections in macro theories were better understood. The present paper seeks to contribute to this objective by proposing a model of imperfect financial intermediaries in a production economy. To this end, we set up an environment in which firms seek both equity and debt financing under endogenous opacity. This means that some uncertainties in the producer performance are, in principle, resolvable in advance of the financing decision when the appropriate asset management regime is chosen, but incentives in financial institutions may work against the resolution. We are interested in consequences of this kind of imperfections for interest rates, capital formation and output in the affected real sector. In this paper, we discuss a two-period setup, mainly for reasons of space economy, although a multi-period generalization would constitute no conceptual problem under the chosen approach.
The firms have production functions with uncertain total factor productivity. This uncertainty has two components. The first is a systemic risk factor whose distribution function is known to everyone. In addition, there is a firm-specific component (firm’s type) which is known to the firm management but cannot be precisely and credibly communicated to either equity investors or wholesale banks. The firm management can only send a public signal about the productivity level as a whole, in which systemic uncertainty contaminates the message about the idiosyncratic productivity component value. Only a loan manager with specific expertise (retail relationship banker) has the necessary non-transferrable skills to learn the borrowing firm’s type. Such a delegated manager can be hired by the wholesale bank for a fee to set the lending rate and collect the proceeds.
The first distinguishing feature of the model is that return on real investment is affected by a specific input required by the corporate governance mechanism in place in the firm. The input can be thought of as a separate strain of managerial human capital related to production (not to be mixed up with the knowledge about technology type, as in the previously mentioned relationship banker case). It is firm-specific and consequently, no individual is able to distribute its provision among all firms. This fact serves as an obstacle to full-fledged diversification of equity holdings by retail investors. For simplicity, we concentrate on the extreme case by assuming that each of the retail investors can only observe the human capital level in a single firm. Then, by selecting the right parameters one can generate an economy in which holding shares in other firms is strictly dominated by only holding shares of the firm whose human capital level one knows. Thus, equity financing is possible but share demand only comes from a subset of knowledgeable investors.
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