Claim 3

Less efficient financial intermediation or lower banks’ cost of funds increase the projects’ risk in a competitive equilibrium.

Proof – Let the cost of banks’ monitoring be kz(ji), k being a shift parameter measuring the efficiency of financial intermediation. Equations (7a) and (8) imply that

In terms of Figure 2, a less efficient monitoring technology rotates the bold curve clockwise around A, to AB, leading to higher risk in the competitive equilibrium. Similarly, a lower banks’ cost of fund shifts the bold curve upward, by the extra cost, increasing thereby the risk undertaken in a competitive equilibrium. Note that (8‘) also implies that -—->0. K 4 d[k/{(l + rc)H}]

Hence, we conclude that a higher supervision/start up costs ratio, k/{(l + rc)H}, increases the projects’ risk in a competitive equilibrium.

Example

Consider the case where monitoring technology and productivity are characterized by constant elasticities,

Some agents have access to an outside income in period 1, denoted by Y. These agents supply their saving, S, demanding real interest rate rc = p for S<Y.

Welfare and financial integration

We consider now the implications of financial integration. We start the discussion with the characterization of the social welfare function, being the sum of the expected surplus of all domestic agents — producers, banks and savers. The welfare contribution of project x is obtained by summing (3) and (6), resulting in

We assume an internal solution in autarky, where the demand for investment is satisfied by the supply of saving at rc=p, and therefor savers’ surplus is zero.

We consider a continues version of the model, where the ‘number’ of projects of productivity x is measured by /(x) [i.e., the mass of projects the productivity index of which is between x and x + e is /(*)£]. The social welfare function is the expected surplus aggregated across all the realized projects