Fighting For The Best, Losing With The Rest: A case for barriers to entry into financial intermediation

The Jumpstart Our Business Startups (JOBS) act of 2012 aims at increasing funding access for young firms by easing securities regulation. This motivated us to ask if there is a role for regulation in the market of funds for... [ view full abstract ]

The Jumpstart Our Business Startups (JOBS) act of 2012 aims at increasing funding access for young firms by easing securities regulation. This motivated us to ask if there is a role for regulation in the market of funds for firms that lack collateral and have a large uncertainty about their ability to generate profits. To answer that we characterize optimal financial contracts in a competitive environment with risk, adverse selection and limited liability. We find that competition among financial intermediaries always forces them to fund projects with negative expected returns both from a private and from a social perspective. Intermediaries use steep payoff schedules to screen entrepreneurs, but limited liability implies this can only be done by giving more to all entrepreneurs. In equilibrium, competition for the best entrepreneurs forces intermediaries to offer better terms to all customers, there is cross subsidization among entrepreneurs and intermediation profits are nil. The three main features of our framework (competition, adverse selection and limited liability) are necessary to get the inefficient laissez-faire outcome and a role for barriers to entry into financial intermediation. Our result still holds when firms can collateralize some portion of the credit as long as an unsecured fraction remains.