Banks versus Bonds: A Simple Theory of Comparative Financial Institutions
We use a simple, graphical moral hazard model to compare monitored bank lending versus non-monitored bond issues as sources of external funds for industry. We contrast the conditions that theoretically favor each system, such as the size and number of ﬁrms, with conditions prevailing when these ﬁnancial systems were developed during the British and German Industrial Revolutions. Then, to address the question why diﬀerent systems have persisted, we embed the model in an entry game in which ﬁrm size and number are endogenous. We show that multiple equilibria can exist if ﬁnanciers take the industrial structure as given and vice versa. Finally, we compare these equilibria in welfare terms.
Baliga, Sandeep and Polak, Ben, "Banks versus Bonds: A Simple Theory of Comparative Financial Institutions" (1995). Cowles Foundation Discussion Papers. 1343.