Multiple Bank-Lending: Diversification and Free-Riding in Monitoring

Abstract

This paper analyzes the optimality of multiple-bank lending, when firms and banks are subject to moral hazard and monitoring is essential. Multiple-bank lending leads to higher per-project monitoring whenever the benefit of greater diversification dominates the costs of free-riding and duplication of effort. The model predicts a greater use of multiple-bank lending when banks have lower equity, firms are less profitable and monitoring costs are high. These results are consistent with some empirical observations concerning the use of multiple-bank lending in small and medium business lending.

Keywords: individual-bank lending, multiple-bank lending, monitoring, diversification, free-riding problem

JEL Classification: D82, G21, G32