, Volume 27, Issue 1, pp 5-26
Date: 14 Apr 2005

Information Monopoly and Commitment in Intermediary-Firm Relationships

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A bank may use the private information that it acquires through monitoring to hold up borrowers. This “information monopoly” of the bank may inefficiently distort the borrower’s investment decisions in environments where moral hazard is prevalent. The paper analyses how this problem is resolved within bank-firm relationships. In the benchmark case when the bank can contractually commit to future actions, the optimal contract turns out to be ambiguous in nature. When commitment contracts cannot be written, firms have an incentive to develop multiple banking relationships in order to decrease the “inside” banks’ bargaining power. However, with costly monitoring, this may defeat the initial purpose for contracting with a financial intermediary, namely information production. The paper argues that when contractual commitment is not feasible, bank size may serve as an alternative commitment device that prevents the bank from holding up borrowers in the future.