This paper considers a model of financial intermediation based on the existence of a moral hazard problem in the choice of investment projects by a heterogeneous population of entrepreneurs. Two alternative ways of funding these projects, called direct (or market) and monitored (or bank) finance, are analyzed. Under monitored finance the entrepreneurial moral hazard problem is ameliorated, in comparison to direct finance, at a certain cost. It is shown that entrepreneurs with large wealth relative to the size of the project will obtain direct finance, entrepreneurs with intermediate wealth will be unable to obtain credit. The analysis sheds light on the validity of certain explanations of the empirical behaviour of short-term credit markets over the business cycle.
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