FINANCIAL SECTOR REFORMS
377
applications, it faces the problem of having to monitor the behaviour of borrowers.
If a lender monitors the borrower, competitors in the banking industry such
as equity investors can free ride on this effort. If several lenders make loans to
the same borrower, they may duplicate each other’s monitoring effort or rely
on each other’s monitoring effort, so that no one actually supervises the bor-
rower. Diamond
4
shows how a large bank solves these informational problems
at a stroke by taking the firm off-market and becoming the sole provider of
capital. This takes the form of a loan that promises a fixed ...
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