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Monitoring and Reputation: The Choice between Bank Loans and Directly Placed Debt

Douglas W. Diamond^1,2

¹ University of Chicago · ² Federal Reserve Bank of Richmond

This paper determines when a debt contract will be monitored by lenders. This is the choice between borrowing directly (issuing a bond, without monitoring) and borrowing through a bank that monitors to alleviate moral hazard. This provides a theory of bank loan demand and of the role of monitoring in circumstances in which reputation effects are important. A key result is that borrowers with credit ratings toward the middle of the spectrum rely on bank loans, and in periods of high interest rates or low future profitability, higher-rated borrowers choose to borrow from banks.

DOI

10.1086/261775

Volume

99 (4)

Pages

689-721

Language

en

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