A Smoke Screen Theory of Financial Intermediation

This paper explores the role of diversiflcation and size in protecting in- formation. We present a simple two period credit market with a sophisti- cated lender faced with competitors who free ride on his screening activity. Absent commitment problems, the lender funds one borrower and exerts optimal evaluation. When borrowers cannot commit to a long term re- lationship, the free riding problem is responsible for too little evaluation. We show how this problem can be mitigated by simultaneously flnancing several borrowers. This efiect provides a rationale for intermediaries as an 'information garbling' device.