, Volume 16, Issue 1, pp 77-91
Date: 18 Feb 2009

Bank Monitoring and Role of Diversification

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I present a framework of banking in which banks’ main role is to monitor their borrowers. Within this framework I analyze the benefits of diversification and the threats of systemic risk and inter-bank competition. Diversification improves banks’ monitoring incentives. High systemic risk not only hampers banks’ monitoring incentives, but also makes diversification less effective. I also show that competition lowers monitoring incentives. I match the insights of the analysis with the abundant literature on the role of banks on the asset-side and provide some implications for recent developments in banking.