Investment, Liquidity Risk, and the Transparency of Financial Intermediaries (Preliminary)

In this paper, we study the implications for business activity of a lack of balance sheet transparency in intermediaries. To do so, we adopt a model of intermediated entrepreneurial investment in which the assets held by intermediaries can be monitored only imperfectly. In our model, these assets matter, because intermediaries insure Þrms against the possibility of a liquidity shock. We show that lack of transparency reduces the amount of leverage available to the Þrm, because intermediaries must be provided with incentives to honor Þnancial commitments. As a result, investment and return on Þrm capital are reduced. An endogenous transparency parameter is increasing in the aggregate wealth of the productive sector, so that an externality accrues to individual Þrms. It follows that aggregate investment and productivity increase more than proportionally with the wealth of the productive sector, even when technology exhibits constant returns to scale. ∗Thanks are due to Dean Corbae for invaluable discussions; and to Marla Ripoll, Jack Ochs, and other participants at a seminar at the University of Pittsburgh in the Spring of 2001. All remaining errors are my own.