The cost of capital in a model of financial intermediation with coordination frictions

Abstract

This paper studies the impact of coordination frictions in financial markets on the cost of capital of real sector projects. In the model, a financial intermediary seeks to raise funds from many small investors, to finance a capital-intensive project. Investors face a coordination problem, as more capital invested in the project increases its chances of success. We employ a global games refinement to characterize the unique equilibrium of the game. The model features a non-monotonic relationship between the cost of capital and project profitability. There exists a "socially optimal" price of capital that maximizes the probability of project success. However, fee-maximizing intermediaries set a return that is higher than the optimal rate. This higher cost of capital is the result of coordination frictions and suggests an inefficiency of the intermediation process. The model best characterizes project finance investments funded through bond markets and yields implications for their cost of capital.

Keywords: financial intermediation, coordination frictions, Global games, Optimal return, Strategic uncertainty

JEL Classification: D82, C72, G21, G32