Optimality of Debt Contracts for Financial Intermediaries

We first prove that the debt contract is the optimal contract between entrepreneurs and arbitrary financial intermediaries in a model where the bank faces an endogenous bankruptcy penalty (as in Diamond (1984)) - the optimality for depositors has already been shown in Diamond (1984). We then show that this does not hold in general if monitoring is done ex post (as in Galeand Hellwig (1985)). However, using the large deviation principle, we prove that optimality of debt contracts holds for “sufficiently large” (but still finite) intermediaries.