The Adverse Selection Approach to Financial Intermediation: Some Characteristics of the Equilibrium Financial Structure

This paper examines an adverse selection economy in which efficient resource allocation is supported by intermediary contracts (coalitions). Agents differ along an ex ante publicly observable dimension, so that the equilibrium arrangement yields a diverse set of financial arrangements among borrowers, lenders and intermediaries. Loans made by intermediaries would appear to be mispriced relative to a naive benchmark that ignores the (unobservable) adverse selection aspects of the environment. The model also yields an equilibrium mix of intermediated and direct finance which is broadly consistent with popular notions about the determinants of that mix.