Journal Review

FINANCIAL INTERMEDIATION
AS DELEGATED MONITORING:
A SIMPLE EXAMPLE
Douglas W. Diamond
TABLE OF CONTENTS
1. Introduction​
2. Role of Financial Institution
​3. Two Type of Risk
4. Delegated Monitoring
5. Policy Implication
​6. Conclusion
Financial Intermediation as Delegated Monitoring: A Simple Example 3

INTRODUCTION
Financial intermediation is an important part of the modern economy because it
allows funds to flow from investors to entrepreneurs in need of capital for productive
investments. This paper presents a simple model of financial intermediation that
emphasizes the role of delegated monitoring in lowering investors' liquidity and
solvency risks. The model has significant implications for the management and
regulation of financial institutions.
ROLE OF FINANCIAL
INSTITUTION
Financial Intermediation as Delegated Monitoring: A Simple Example 5

ROLE OF FINANCIAL INSTITUTION

• Financial institutions operate as go-betweens for investors and
businesspeople. They borrow money from investors and lend it to
businesspeople in need of funding.
• Financial institutions play an important role in the economy. Investors would
have to monitor entrepreneurs themselves if there were no financial
intermediaries, which would be costly and difficult.
• Financial institutions can specialize in entrepreneur monitoring and credit
risk assessment, allowing them to provide valuable services to both investors
and entrepreneurs.
• Financial institutions, in addition to providing capital, play an important role
in monitoring entrepreneurs to ensure proper use of borrowed funds and risk
management. This monitoring can take many forms, such as verifying
business plans, assessing entrepreneurs' creditworthiness, and monitoring
ongoing business operations.
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TWO TYPES OF RISK

 Financial Intermediation as Delegated Monitoring: A Simple Example 7

TWO TYPES OF RISK

When investing their funds, investors face two types of risk: liquidity risk
and solvency risk.

SOLVENCY RISK LIQUIDITY RISK

• Solvency risk arises when business owners
don't pay back borrowed money. Investors
who have lent money to business owners
who might not be able to pay back the loan
• Long-term investors who have invested in
business owners who may face difficulties
repaying borrowed funds over time face
solvency risk. This can be caused by a
number of factors, such as changes in
market conditions, unexpected business
challenges, or macroeconomic shocks.
• When investors require cash but are unable to
sell their investments at the desired price, they
face liquidity risk. This risk is especially
relevant for investors who have invested in
non-tradable assets.
• Liquidity risk is especially important for
short-term investors who require quick access
to their funds. ( For example, if an investor
buys a bond with a one-year maturity but
needs the funds in six months, they may be
unable to sell the bond quickly or at the
desired price. )
DELEGATED
MONITORING
Financial Intermediation as Delegated Monitoring: A Simple Example 9

DELEGATED MONITORING

• The process by which investors delegate the responsibility of monitoring

entrepreneurs to financial intermediaries is referred to as delegated
monitoring.
• Monitoring delegation allows investors to focus on their investment
decisions while financial intermediaries assess credit risk and monitor
entrepreneurs.
• Overall, delegated monitoring is a critical function of financial
intermediaries and allows for efficient allocation of capital and risk
management in the economy.
Financial Intermediation as Delegated Monitoring: A Simple Example 10

EXAMPLE OF DELEGATED MONITORING

• An investor can lend an entrepreneur $100,000, but they must first

monitor the entrepreneur's business activities and evaluate the
credit risk. As an alternative, the investor may give the money to a
financial intermediary, like a bank, who would then lend the money
to the business owner and keep an eye on how they are using it.
• The delegation of monitoring allows the investor to avoid the costs
and risks associated with monitoring the entrepreneur themselves,
while still earning a return on their investment.
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POLICY IMPLICATION
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POLICY IMPLICATION
The delegation of monitoring has significant policy implications for financial
institution regulation.
Appropriate regulation is important to ensure financial stability and
compliance with government policies. Regulation can help reduce the risks
of financial institutions and prevent systemic risks that can harm the
economy.
Regulators must devise policies that encourage financial intermediaries to
manage risk appropriately while still allowing entrepreneurs and other
borrowers access to credit.
Overall, effective regulation of delegated monitoring in financial
intermediation is required to ensure the stability and efficiency of financial
markets.
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Financial Intermediation as Delegated Monitoring: A Simple Example

CONCLUSION
Financial intermediaries play a crucial role in delegated monitoring, which enables
effective capital allocation and risk management in the economy. Financial
intermediaries are essential in helping investors manage their solvency and liquidity
risks. Financial intermediaries concentrate on determining credit risk and keeping an
eye on business owners while investors concentrate on their investment decisions.
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