Liquidity Provision, Interest-Rate Risk, and the Choice between Banks and Mutual Funds

This paper incorporates interest-rate risk and borrower moral hazard into the Diamond-Dybvig model. These new features enable a comparison of liquidity provision by monitoring and nonmonitoring financial intermediaries (banksandmutual funds). Bank monitoring weakens lending-rate constraints and thereby leads to improved risk sharing and enhanced interim investment. All else the same, high levels of consumer liquidity needs and risk aversion, high levels of interest rates and interest-rate variability, and low costs of bank monitoring appear to favor the choice of banks over mutual funds.