Abstract

Financial Intermediation and Reputation Effects

In order to explain the existence of financial intermediaries, it is necessary to demonstrate the advantages of a two-tier over a single-tier financing relationship. In the relationship between an intermediary and a financed enterprise, problems can be avoided that would otherwise arise from non-co-operative modes of behaviour where several capital donors directly invest in a company. On the other hand, it is common practice for a single intermediary to fund a large number of enterprises simultaneously. It has been common knowledge for quite some time that the diversification effects made possible thereby mitigate possible incentive problems between the intermediary and the investors. Another advantage of intermediaries, not yet noted to any significant extent, is that - over time, i.e. where a sequential approach is taken - there is greater probability that the capital demand of intermediaries is more often more substantial than that of an individual company. This explains why, in order to build or cultivate, as the case may be, their reputation, financial intermediaries are, more often and more widely than individual companies, prepared to behave properly. This holds true for young enterprises in particular, which see little point in investing in their own reputation because of their still limited perspectives of continuing in operation. Using the services of financial intermediaries is thus a logical proposition especially for young enterprises, in order to avoid incentive problems.