Ulf Axelson's webpage

Leveraging to Lend: A Theory of Lax Credit

Abstract:
A pervasive feature of financial intermediation is the use of third-party deal-by-deal capital in addition to balance sheet capital to finance investment activity. This paper studies how third-party capital and decentralized fundraising jointly shape competition, screening, and welfare in intermediated credit markets. We show that third-party capital serves a novel economic function: it allows informed intermediaries to separate screening decisions from surplus sharing, thereby intensifying competition and reducing the cost of capital to firms. Yet it also amplifies a dynamic adverse selection externality, resulting in excessively lax screening and overinvestment. Consequently, although entrepreneurs benefit from intermediary third-party leverage, restricting third-party financing can raise social welfare.