Moral Hazard and Banking Competition

We construct a model of bank’s financing under moral hazard. The bank as an intermediary borrows funds from the investors (depositors) to channel them to the entrepreneurs who run the projects of the firm. The firm’s project return is risky, which is the source of the moral hazard. Also the investors are uncertain about whether their investment results in a positive return under scrupulous behavior of bank, but bank promises the investors to monitor the project properly that is the second source of moral hazard. We ignore the incentive issues related to the deposit insurance, and focus on uninsured but monitored bank debt. We characterize the conditions under which the double moral hazard competition leads to an excessive level of risk and insufficient monitoring.