Question

How can using indirect finance rather than direct finance reduce agency costs associated with monitoring funds demanders?

Answer 1

A large FI has a huge incentive in monitoring the behavior of funds demanders in an indirect financing. They hire & train experts who are aware of collecting information about funds demanders & evaluating whether the funds demanders are acting accordingly. But in case of direct finance, a fund demander sells claims to the public at large. In this case there is only little incentive for an individual claim holder to monitor & attempt to enforce good behavior on the part of the funds user. This benefit of monitoring & enforcing is shared among all the claim holders but the cost has to be borne by the sole individual. This is referred to as free miler problem. The agency costs have the chance of getting reduced if there is improvement in monitoring the behavior of the borrower.