Credit market imperfections and the separation of ownership from control

This paper offers a model of credit markets with adverse selection and moral hazard. The equilibrium is highly inefficient, and the underlying reason is the zero-profit condition imposed by competing financial intermediaries which gives very high powered incentives to entrepreneurs. The paper demonstrates that when entrepreneurs can hire a manager to run their projects, the inefficiencies are prevented. This is because the manager is not the residual claimant of the returns, and hence has low powered incentives. Therefore, the divergence of interests between owners and managers may have beneficial effects as well as the often emphasized costs. (C) 1998 Academic Press.