This paper, authored by Bengt Holmstrom and Jean Tirole, examines the relationship between financial intermediation, loanable funds, and the real sector. The authors develop an incentive model where firms and intermediaries are both capital-constrained, analyzing how the distribution of wealth across these entities affects investment, interest rates, and monitoring intensity. They find that capital tightening (credit crunch, collateral squeeze, or savings squeeze) disproportionately affects poorly capitalized firms, with interest rate effects and monitoring intensity depending on the relative changes in various components of capital. The model's predictions align with observed lending patterns during recent financial crises in Scandinavia. Additionally, the model suggests that in an unregulated environment, the market response to a credit crunch is to allow solvency ratios of intermediaries to decline, indicating that more permissive capital adequacy requirements may be appropriate regulatory responses. The paper also explores the role of monitoring as a substitute for collateral and the implications for solvency ratios and capital adequacy requirements.This paper, authored by Bengt Holmstrom and Jean Tirole, examines the relationship between financial intermediation, loanable funds, and the real sector. The authors develop an incentive model where firms and intermediaries are both capital-constrained, analyzing how the distribution of wealth across these entities affects investment, interest rates, and monitoring intensity. They find that capital tightening (credit crunch, collateral squeeze, or savings squeeze) disproportionately affects poorly capitalized firms, with interest rate effects and monitoring intensity depending on the relative changes in various components of capital. The model's predictions align with observed lending patterns during recent financial crises in Scandinavia. Additionally, the model suggests that in an unregulated environment, the market response to a credit crunch is to allow solvency ratios of intermediaries to decline, indicating that more permissive capital adequacy requirements may be appropriate regulatory responses. The paper also explores the role of monitoring as a substitute for collateral and the implications for solvency ratios and capital adequacy requirements.