Consider a banking model with delegated monitoring. Markets are perfectly competitive. There is a large number of borrowers who lack the funds and a large number of lenders who have the funds. Each lender has 10 goods to lend. Each borrower can invest in one project which requires 20 goods. The return of each project is risky, with probability 1/2, the project fails and yields nothing. The returns are independent across different projects (borrowers). However, the return is private information for the borrower. Other people have to incur a cost equivalent to 5 goods to monitor the outcome from investment.
a) Consider direct lending. Explain why each lender has to pay the monitoring cost when the borrower unable to repay loans. What is the monitoring cost for each project?
b) Under direct banking, what is the average gross rate of return for each lender? Explain