Competitive markets bidding down prices toward the minimum cost of producing goods or services is an opaque process. The problem can be addressed with a careful social accounting of the costs and benefits of activities using derivatives. Until this accounting is done, the derivatives industry can expect continued intransigence by regulatory authorities reluctant to allow innovations which threaten losses. For the remainder of this article I will describe some research which begins the necessary social accounting for banks and other depository institutions which intermediate funds between lenders and borrowers. His model characterizes the optimal forms of contracts used by these institutions.
Banks specialize in monitoring activities which obtain economies in monitoring.
Depositor delegation of monitoring activities enables entrepreneurs to realize a portion of these economies. However, delegation of monitoring results in incentive problems referred to as delegation costs. These costs are reduced by diversifying loan portfolios. Diversification is achieved by writing firm-specific loan terms. This effort achieves a separation between the risks faced by depositors and the risks stemming from contracts made between entrepreneurs and banks.