An Evolutionary Process of Asset Transformation of Financial Intermediaries

Abstract

This paper models the evolutionary process of banks whose roles are information production and asset transformation, the latter being a process of issuing liabilities (deposits) and then investing the proceeds in other risky assets. After we establish the "mixed quality equilibrium" in a capital market where managers and investors have asymmetric information about project quality, we derive cost conditions which motivate the emergence of banks as information producers and asset transformers. If asset transformation is a second-best choice relative to information production, asset transformation could be a mechanism for reducing the incentive cost of banks. A necessary condition for asset transformation to be a first-best choice is that banks are less risk averse than investors.