From Doug Diamond and Anil Kashyap. Self-recommending, as Tyler would say. Diamond’s paper “Financial intermediation and delegated monitoring,” is the technical version of what I tried to describe earlier today.

They point out that financial firms are tightening up.

One signal is that there were apparently only two bidders for Lehman, when the ongoing value from operating most of the bank was surely far above the $3.60 share price from Friday. Another is the elevated cost of borrowing that banks are charging each other. A third indicator is the reluctance to take on certain types of risk, such as jumbo mortgages, so that the cost of this type of borrowing is unusually high.

The latter point is why I keep saying that the government should lower capital requirements for banks that make sound mortgage loans (where borrowers put 20 percent down). Otherwise, either borrowers are going to be shafted or the government is going to wind up funding those loans.

Thanks to Greg Mankiw for the pointer.