A joint workshop with the Centro de Estudios Monetarios y Financieros (CEMFI) on `Financial Intermediation' was held in Madrid on 13/14 January. The workshop was organized by Rafael Repullo of CEMFI and Co-Director of CEPR's Financial Economics programme.

Patrick Bolton (ECARE, Université Libre de Bruxelles and CEPR) presented `Direct Bond Financing, Financial Intermediation and Investment: An Incomplete Contract Perspective', written with Xavier Freixas. The paper argues that bank loans and bonds are distinct forms of debt financing, and that banking theory lacks answers to three questions: first, what are the key differences between bank debt and bonds; second, why the composition of debt varies over the business cycle; and third, whether mutual funds and direct market-based financing are progressively replacing bank financing. The main advantage of lending is that it is easier to renegotiate debt than bonds; the main drawback is the cost of financial intermediation, arising from the asymmetry of information between bank managers and shareholders or depositors. The paper derives a credit market equilibrium in which debt coexists with bonds. The model can be used to assess the welfare implications of various bank regulations, as well as address the three unanswered questions.

Helmut Bester (Tilburg University and CEPR) observed that a major assumption of the paper is that bondholders (but not banks) are unable to forgive part of their debt. Some empirical evidence shows that public debt restructuring plays an important role for firms in financial distress. In addition, the introduction of intermediation costs generates a trade-off between bank loans and bonds. In terms of the model's macroeconomic predictions, however, there is no clear evidence that these costs vary substantially over the business cycle. Enrico Perotti (University of Amsterdam) thought that the model offers a fresh view of banks not as information gatherers, but as flexible coordinators in financial distress. Unfortunately, because the model assumes that liquidation is always inefficient, it overstates the benefits of renegotiation, particularly in the welfare implications for deposit insurance. Evidence that banks are better at assisting firms in distress than dispersed market investors provides convincing support for the paper's view of banks as facilitators.

Rafael Repullo presented `Entrepreneurial Moral Hazard and Bank Monitoring: A Model of Financial Intermediation', written with Javier Suárez. The paper considers a model of financial intermediation based on the existence of a moral hazard problem in the choice of investment projects by a heterogeneous population of entrepreneurs. Two alternative ways of funding projects, called direct (or market) and monitored (or bank) finance, are analysed. Under monitored finance, the entrepreneurial moral hazard problem is ameliorated at a certain cost. Entrepreneurs with large wealth relative to the project size will obtain direct finance, those with intermediate wealth will get monitored finance, and those with little wealth will fail to obtain credit. The analysis helps to explain the empirical behaviour of short-term credit markets over the business cycle.

Ian Jewitt (University of Bristol and CEPR) welcomed a model capable of generating testable implications on the cyclical behaviour of the preferred mode of finance. He suggested that it would be interesting to develop the model to draw out testable differences between the implications of incomplete contracting assumptions and asymmetric information assumptions. Hans Wijkander (University of Stockholm) noticed that one important motivation for the development of analyses of financial intermediation is to explore the role of credit markets in macroeconomic activity. He argued that there is a great deal of casual evidence supporting the view that credit markets have magnified upswings and downturns. Credit markets may even have been the source of such fluctuations.

In `Diversification and Competition: Financial Intermediation in a Large Cournot-Walras Economy', Oved Yosha (Brown University and Tel Aviv University) considered an economy under uncertainty where risk sharing is achieved through purchase of securities from partially diversified financial intermediaries, who behave as Cournot competitors. This paper suggests that, in a sufficiently large economy, risk sharing through (imperfectly competitive) financial intermediaries is an almost perfect substitute for other forms of risk sharing. This is relevant for developing economies where centralized securities markets are not well developed, and where there is an oligopolistic market structure in the financial sector. The analysis suggests that as an economy grows, the number of financial intermediaries should be allowed to increase, and they should be encouraged to become larger and more diversified. It also suggests that perfect competition is achieved relatively fast, whereas the degree of diversification may improve more slowly. Thus, it may become desirable gradually to shift the focus of government regulation from competition-enhancing measures to the encouragement of diversification.

Xavier Vives (Institut d'Analisi Economica, CSIC and CEPR) observed that the paper needs to develop better intuition about why uncertainty slows down convergence of utilities but not of prices. Two model extensions would be worth considering: first, introducing the assumption of rate competition among intermediaries instead of Cournot; and second, making intermediaries arise endogenously. Both have potentially important implications for welfare and policy analysis. Ernst-Ludwig von Thadden (Universität Basel) thought that both the strength and weakness of the paper is its simplification of the intermediary sector. It adapts the theory of imperfect competition in large economies to include intermediation by assuming that intermediaries produce the good, `future consumption'. This ignores the two-sided nature of intermediary activity.

Robert Gary-Bobo (Université de Cergy-Pontoise) presented `Credit Crunch in a Model of the Banking Industry', written with André de Palma. The paper analyses an oligopoly model of the banking industry in which each bank chooses a portfolio and a balance sheet structure, knowing that if bad signals are received about the quality of its assets, depositors can decide to withdraw and force the bank into costly asset liquidation or bankruptcy. It is shown that equilibrium lending exhibits downward discontinuities at critical values of parameters such as bank capital and the level of the demand for loans. In addition, there may exist multiple equilibria, corresponding to radically different levels of loan supply. These provide a possible microeconomic explanation for the credit crunch phenomenon.

Thomas Gehrig (Universität Basel and CEPR) argued that the paper is about asset choice in an oligopolistic context rather than credit crunches. The topic is interesting since incentives to excessive risk-taking can be counteracted by competitive forces. Repullo noted that the notion of credit crunch used in the paper is not the standard one (that is, a leftward shift in the supply of bank loans), but one characterized by a switch from a risky to a safe equilibrium due to an exogenous shock or sunspot. To explain the difference, he noted that in this model, a reduction in the bank's equity capital may lead to a credit explosion.

Jürg Blüm (Universität Basel) presented `The Macroeconomic Implications of Capital Adequacy Requirements for Banks', written with Martin Hellwig. The paper argues that capital adequacy regulation for banks may reinforce macroeconomic fluctuations if negative shocks to aggregate demand reduce the ability of firms to service their debts to banks. Reduced debt servicing lowers bank equity, and, because of capital adequacy requirements, this in turn reduces bank lending and industry investment.

Sudipto Bhattacharya (Université Catholique de Louvain and CEMFI) agreed with the paper's methodological emphases on the continuing nature of capital adequacy requirements, and the need to draw sharp distinctions between systematic (non-diversifiable) and idiosyncratic shocks. However, he was sceptical about the empirical reasonableness of such assumptions as non-availability of external equity financing for banks, and strict non-substitutability of bank versus other sources of financing for commercial borrowers. Empirically, he was also uncertain about the assumption that many US banks were equity-constrained in their lending in the early 1990s. Oren Sussman (Hebrew University of Jerusalem and CEMFI) noted that the paper investigates how procyclical movements in bank equity feed back into bank lending, investment and economic activity - with and without capital adequacy requirements. It is argued that procyclical movements in the equity loan ratio are a part of the normal functioning of a banking system: imposing a mechanical and rigid equity loan ratio will force banks to contract loans when equity falls, which may exacerbate the business-cycle. It is assumed that the capital adequacy constraint is always binding, and his main concern was about the robustness of this argument.

Gabriella Chiesa (Università di Brescia) presented `Banking Competition with Endogenous Capacity Constraints'. The paper analyses banking price competition for lending, when banks' screening activity is costly and cannot be monitored by outsiders (investors), and when a firm's projects can be evaluated by its `inside' banks, a subset of the banks in the economy. Credit rationing results from decentralized lending decisions, leading to mismatch between banks and firms (some banks lend below their capacity and some firms are credit constrained), and decentralized price decisions, leading to shrinking of the equilibrium level of banks' aggregate lending capacity. Equilibrium credit rationing is higher the more fragmented the banking system, and the lower the aggregate value of banks' capital.

Marie-Odile Yanelle (DELTA) and Kai-Uwe Kühn (Institut d'Analisi Económica) noted that the main point of the paper is that excessive credit rationing may occur when entrepreneurs cannot deal with all banks because of the presence of switching costs. Such inefficiencies arise from coordination problems among banks, and in the model critically depend on the specification of price competition in the loan market. Even with switching costs, no inefficient credit rationing can occur in equilibrium, if banks set prices simultaneously. When banks set prices sequentially, as in the paper, coordination problems may arise. This, however, appears to be very specific to the particular formulation adopted so that one should be cautious when claiming that inefficient rationing results from switching costs.

Xavier Vives presented `Imperfect Competition, Risk-taking and Regulation in Banking', written with Carmen Matutes. The paper develops a model of banking competition which disentangles the roles that limited liability, deposit insurance, and rivalry for deposits play in determining risk-taking incentives on both the asset and liability side of the balance sheet. In all market configurations (uninsured or insured), banking rivalry yields excessive deposit rates when social failure costs are high or when competition is intense. Maximum risk-taking incentives exist with flat-premium deposit insurance and minimal with risk-based insurance. In an uninsured market, risk-taking on the asset side is implied by limited liability and the presence of moral hazard. With flat-premium deposit insurance, maximum risk-taking incentives exist even without moral hazard.

Ulrich Hege (Hautes Études Commerciales, Jouy-en-Josas) emphasized the importance of the link between imperfect banking competition and banking regulation. In the model, the problematic instrument of an interest rate ceiling could be substituted if the social costs of bank failure are internalized in the bankruptcy procedure. Regulatory forbearance should also be incorporated explicitly. Bruno Biais (Université de Toulouse) noted that one implication of the paper is that if the bank's asset risk is not observable, regulation of the risk is needed, either directly or through deposit insurance premia increasing with risks. He suggested two other solutions: first, for commercial banks, deposit financed, risk taking can be awarded by rewarding bank managers on their ability to repay deposits, rather than on their ability to generate high profits; second, for investment banks, seeking to maximize profits, equity financing may be more appropriate than deposits.

Xavier Freixas (Universitat Pompeu Fabra) and Jean-Charles Rochet (Université de Toulouse and CEPR) presented `Fair Pricing of Deposit Insurance: Is it Possible?' answering in the affirmative but that it is not desirable. Elaborating on the work of Chan, Greenbaum and Thakor which contends that fairly priced deposit insurance is incompatible with free competition in the banking sector, in the presence of adverse selection, the paper show that as soon as one introduces a real economic motivation for private banks to manage the public's deposits, then fairly priced deposit insurance is never desirable, precisely because of adverse selection. The characteristics of the optimal premium schedule is computed, which indicates the trade-off between the costs of adverse selection and of `unfair competition'.

Arnoud Boot (University of Amsterdam and CEPR) observed that the paper gets around the incompatibility of both incentive incompatibility and fair pricing of deposit insurance by introducing rents in the production of deposit-linked banking services. He noted that the paper shows the need for cross-subsidies, and asked whether these are sustainable and whether better, but taxed, high quality banks still have the same incentives. The paper seeks to extract policy implications but, he asked, would this not require a setting in which a rationale for deposit insurance and capital, and distortions are jointly present.

Sudipto Bhattacharya and Jorge Padilla (CEMFI and CEPR) presented `Dynamic Banking: A Reconsideration'. The paper compares the welfare implications of financially intermediated and stock market consumption-investment allocation, with (and without) government interventions, in overlapping generations economies with (and without) shocks to agents' intertemporal preferences. It is shown that government interventions, such as tax-subsidy schemes or the provision of real money balances, lead to stock market allocations that are no inferior to those achieved under financial intermediation. Furthermore, the necessary interventions are qualitatively no different from those required to implement stationary optimal allocations in overlapping generations models without uncertainty about agents' consumption preferences. Thus, the provision of liquidity is tangential to stock market efficiency.

Fabrizio Zilibotti (Universitat Pompeu Fabra) admired the paper's elegant discussion of efficiency issues arising in overlapping generation models with an `illiquid technology'. On the one hand, it holds true that the overlapping generations issue which drives the inefficiency is solved by an economy with intermediaries, whereas government intervention is required in a stock market economy. But on the other hand, when stochastic life duration plus asymmetric information are introduced, financial intermediation is shown to be no longer superior to a stock market solution. Government intervention is necessary to restore efficiency in both cases. There are some technical issues concerning the characterization of the optimal stationary allocation: when a linear technology is used and intergenerational transfers are permitted it is possible to make all agents better off than in any stationary allocation by inducing a path of sustained growth.