Credit Market Equilibrium with Bank Monitoring and Moral Hazard

Abstract

We characterize a credit market equilibrium in which banks coexist with capital markets and firms obtain funding from both sources. An incentive problem exists between the firm's insiders and outside providers of capital. Banks can provide not only credit but also monitoring services. We show that when banks cannot precommit to a particular level of monitoring, there is a unique credit market equilibrium with firms being financed with a combination of bank credit and external capital. In this equilibrium, a marginal substitution of bank credit for capital market financing would raise the firm's stock price. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.