Risk and intermediation in a dual financial market economy

We study the competitive equilibria of a simple economy with moral hazard and intermediation costs. Entrepreneurs can simultaneously get credit from two types of competing institutions: 'financial intermediaries' and 'local lenders'. The former are competitive firms issuing deposits and having a comparative advantage in diversifying credit risks. The latter are individuals with a comparative advantage in credit arrangements with a 'nearby' entrepreneur. Because of intermediation costs, local lenders are willing to diversify their portfolio by offering some direct lending to nearby entrepreneurs. We show that, in some cases, a fall in intermediation costs, by inducing local lenders to choose a safer portfolio, reduces entrepreneurs' effort and increases the probability of default. In these cases, taxing intermediaries may be welfare-improving. Jel Classification Numbers. A10, D80, G10, O17.