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International Finance Discussion Papers
The International Finance Discussion Papers logo links to the International Finance Discussion Papers home page Incomplete Insurance, Irreversible Investment, and the Microfoundations of Financial Intermediation
Robert A. Johnson
1986-289  (July 1986)

Abstract:  The financial intermediary is shown to result from a market imperfection related to the costly monitoring of the actions of consumers. In such an environment complete insurance is not obtainable and consumers respond by holding some of their wealth as precautionary balances in order to self-insure. Precautionary balances are those financial vehicles which permit one to invest and then liquidate with the smallest amount of loss because of the "sunk costs" associated with the transaction. An economy of N identical consumers is created and it is shown that a financial intermediary which collects the precautionary balances of the community can then implement risk sharing and liberate social resources for greater investment.

Full paper(442 KB PDF)

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