The paper extends Diamond's (1984) analysis of financial intermediation to allow for risk aversion of the intermediary. It shows that, as in the case of risk neutrality, the agency costs of external funds provided to an intermediary are relatively small if the intermediary is financing many entrepreneurs with stochastically independent returns. Even though the intermediary is adding rather than subdividing risks, the underlying large-numbers argument is not invalidated by the presence of risk aversion. With risk aversion of entrepreneurs as well as the intermediary, financial intermediation provides insurance as well as finance. In contrast to earlier results on optimal intermediation policies under risk neutrality, the paper shows that when an intermediary is financing many entrepreneurs with stochastically independent returns, optimal intermediation policies must shift return risks away from risk averse entrepreneurs and impose them on the intermediary or on final investors.
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