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. However, banks having total risk targets may find that systematic risk levels prevent them from fully exploiting diversification opportunities. This restricts their ability to extend loans. In these cases, derivative contracts enable institutions to lower systematic risk levels and increase their ability to diversify. This use of derivative contracts to hedge systematic risks enables banks to further reduce delegation costs and, in turn, enables them to more effectively intermediate.