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A Dilution Cost Approach to Financial Intermediation and Securities Markets

Author

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  • Xavier Freixas
  • Patrick Bolton
Abstract
This paper proposes a model of financial markets and corporate finance, with asymmetric information and no taxes, where equity issues, Back debt and Bond financing may all co-exist in equilibrium. The paper emphasizes the relationship Banking aspect of financial intermediation: firms turn to banks as a source of investment mainly because banks are good at helping them through times of financial distress. The debt restructuring service that banks may offer, however, is costly. Therefore, the firms which do not expect to be financially distressed prefer to obtain a cheaper market source of funding through bank or equity issues. This explains why bank lending and bond financial may co-exist in equilibrium. The reason why firms or banks also issue equity in our model is simply to avoid bankruptcy. Banks have the additional motive that they need to satisfy minimum capital adequacy requirements. Several types of equilibria are possible, one of which has all the main characteristics of a ¶credit crunch¶. This multiplicity implies that the channels of monetary policy may depend on the type of equilibrium that prevails, leading sometimes to support a ¶credit view¶ and other time the classical ¶money view¶.

Suggested Citation

  • Xavier Freixas & Patrick Bolton, 1998. "A Dilution Cost Approach to Financial Intermediation and Securities Markets," FMG Discussion Papers dp305, Financial Markets Group.
    • Handle: RePEc:fmg:fmgdps:dp305
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    File URL: http://www.lse.ac.uk/fmg/workingPapers/discussionPapers/fmg_pdfs/dp305.pdf
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    Cited by:

    1. Bose, Niloy, 2005. "Endogenous growth and the emergence of equity finance," Journal of Development Economics, Elsevier, vol. 77(1), pages 173-188, June.
    2. Ursel Baumann & Glenn Hoggarth & Darren Pain, 2005. "The substitution of bank for non-bank corporate finance: evidence for the United Kingdom," Bank of England working papers 274, Bank of England.
    3. Bose, Niloy & Neumann, Rebecca, 2005. "Explaining the Trend and the Diversity in the Evolution of the Stock Market," University of Göttingen Working Papers in Economics 47, University of Goettingen, Department of Economics.
    4. Saoussen Ben Gamra, 2009. "Marchés obligataires et stabilité financière: L'expérience asiatique," CEPN Working Papers hal-00574161, HAL.
    5. Saoussen Ben Gamra, 2009. "Marchés obligataires et stabilité financière: L'expérience asiatique," Working Papers hal-00574161, HAL.
    6. repec:got:cegedp:47 is not listed on IDEAS

    More about this item

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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