The role of risky debt and safe assets in unregulated financial intermediaries with costly state verification

We study the delegation of monitoring activity to financial intermediaries that are not subject to regulation. Intermediaries cannot observe the returns of the borrowers’ project directly, and must conduct costly monitoring. Moreover, they face limited liability and have limited commitment when monitoring their loans. We demonstrate that, when intermediaries cannot commit to monitor loans, allowing financial intermediaries to issue risky debt and hold safe assets in their portfolio can mitigate the delegation problem. Moreover, we find that equity, rather than access to safe assets, does not resolve the intermediary’s commitment problem. Finally, we quantify the discipline value of safe assets, finding it to be equivalent to a 2.6% increase in consumption.