Intermediation and Exclusive Representation in Financial Networks

This paper develops a theory of financial intermediation. Consider an environment with repeated financial interactions in which strategic default is possible. We show that if interactions between any lender and borrower are infrequent and if market participants have incomplete knowledge of the patterns of interactions in the market, then all investments must be intermediated. Moreover, each intermediary must exclusively represent many lenders in their interactions with a given borrower, so that she can “punish” the borrower severely for any strategic default by eliminating the borrower’s access to many future loans. To this end, we develop a model of financial networks that are shaped by exogenous forces as well as by lenders’ decisions and new tools to study the ability of market participants to learn about the structure of the financial network. We then characterize networks that are robust – networks that can be sustained in equilibrium given (almost) any belief that is consistent with agents’ knowledge of the network structure. Our characterization sheds light on the complementarity and substitutability of selffinance clauses, the use of collateral, and intermediation; and suggests also that the riskiest and safest assets will be traded using full collateral, whereas the intermediately risky assets will be traded by intermediaries and without full collateral. The effect of macroeconomic conditions and the presence of credit bureaus on the patterns of intermediation are also studied.(JEL: C73, D42, D83, D85, D86, G20, L14)