CREDIT MARKET EQUILIBRIUM WITH BANK MONITORING AND MORAL HAZARD

We characterize a credit market equilibrium in which banks coexist wit h capital markets and firms obtain funding from both sources. An incen tive problem exists between the firm's insiders and outside providers of capital. Banks can provide not only credit but also monitoring serv ices. We show that when banks cannot precommit to a particular level o f monitoring, there is a unique credit market equilibrium with firms b eing financed with a combination of bank credit and external capital. In this equilibrium, a marginal substitution of bank credit for capita l market financing would raise the firm's stock price.