Institutional Liquidity Needs and the Structure of Monitored Finance
Posted: 26 Jul 2002
A financial institution that finances and monitors firms learns private information about these firms. When the institution seeks funds to meet its own liquidity needs, it faces adverse selection ("liquidity") costs that increase with the risk of its claims on these firms. Thus, the institution can reduce its liquidity costs by holding debt rather than equity. Because these costs are passed through to borrowers, firms that depend on monitored finance generally prefer to give the monitoring institution debt rather than equity. One exception is a limited setting with features that resemble venture capital. Institutions with less frequent or less severe liquidity needs have greater appetite for equity and for the debt of more risky borrowers. These predictions are consistent with general patterns of monitored finance.
Keywords: financial institutions, banks, finance companies, life insurers, venture capital, liquidity costs, monitoring
JEL Classification: G21, G22, G23, G24, G32
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