Reputation and the Soft-Budget Constraint (original) (raw)
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Reputation and credit market formation
2005
In this paper we show that reputation formation in endogenously formed relationships is a decisive determinant for the existence and performance of credit markets. In the absence of any third party enforcement of debt repayment the contracting parties succeed in establishing stable bilateral relations in which the borrowers repay out of reputational concerns. As a consequence mutually beneficial trades can take place. The introduction of third party enforcement of debt repayment generates surprisingly small efficiency gains. This is due to the fact that third party enforcement of debt repayment not only solves the moral hazard problem associated with debt repayment but also exacerbates the moral hazard problem that is associated with project choices. Whereas in the absence of third party enforcement of debt repayment most borrowers choose the efficient project, the introduction of third party enforcement causes an increase in the number of inefficient projects. But also in this environment the market participants realize a large fraction of the available gains from trade by forming bilateral relations in which a reputation mechanism forces borrowers to choose the efficient project very frequently.
On Reputation: A Microfoundation of Contract Enforcement and Price Rigidity
The Economic Journal, 2009
We study the impact of reputational incentives in markets characterized by moral hazard problems. Social preferences have been shown to enhance contract enforcement in these markets, while at the same time generating considerable wage and price rigidity. Reputation powerfully amplifies the positive effects of social preferences on contract enforcement by increasing contract efficiency substantially. This effect is, however, associated with a considerable bilateralisation of market interactions, suggesting that it may aggravate price rigidities. Surprisingly, reputation in fact weakens the wage and price rigidities arising from social preferences. Thus, in markets characterized by moral hazard, reputational incentives unambiguously increase mutually beneficial exchanges, reduce rents, and render markets more responsive to supply and demand shocks. JEL Classification: D82, J3, J41, E24, C9
Soft Collateral, Bank Lending, and the Optimal Credit Rating System
SSRN Electronic Journal, 2016
In this paper, we study the optimal credit rating system in an economy where agents need to borrow and have incentives to renege on debt repayments. We show that credit exclusion creates "soft"collateral in the form of a borrower's reputation. Compared with individual lending, bank lending reduces search frictions, which increases the cost of credit exclusion, boosts the value of soft collateral, and facilitates borrowing and lending. A dynamic rating system allows agents' ratings to migrate over time and …ne-tunes agents' incentives. By doing so, it reduces the agency cost, makes better use of soft collateral, and improves social welfare. We show that the optimal rating system is coarse, as we observe in the real world.
2009
The evidence suggests that relational contracting and legal rules play an important role in credit markets but on the basis of the prevailing field data it is difficult to pin down their causal impact. Here we show experimentally that relational incentives are a powerful causal determinant for the existence and performance of credit markets. In fact, in the absence of legal enforcement and reputation formation opportunities the credit market breaks down almost completely while if reputation formation is possible a stable credit market emerges even in the absence of legal enforcement of debt repayment. Introducing legal enforcement of repayments causes a further significant increase in credit market trading but has only a surprisingly small impact on overall efficiency. The reason is that legal enforcement of debt repayments weakens relational incentives and exacerbates another moral hazard problem in credit markets -the choice of inefficient high-risk projects.
Bargaining power and enforcement in credit markets
Journal of Development Economics, 2006
In a credit market with enforcement constraints, we study the effects of a change in the outside options of a potential defaulter on the terms of the credit contract, as well as on borrower payoffs. The results crucially depend on the allocation of "bargaining power" between the borrower and the lender. We prove that there is a crucial threshold of relative weights such that if the borrower has power that exceeds this threshold, her expected utility must go up whenever her outside options come down. But if the borrower has less power than this threshold, her expected payoff must come down with her outside options. In the former case a deterioration in outside options brought about, say, by better enforcement, must create a Lorenz improvement in state-contingent consumption. In particular, borrower consumption rises in all "bad" states in which loans are taken. In the latter case, in contrast, the borrower's consumption must decline, at least for all the bad states. These disparate findings within a single model permit us to interpret existing literature on credit markets in a unified way.
Monitoring in Originate-to-Distribute Lending: Reputation versus Skin in the Game
The Review of Financial Studies, 2021
Banks face liquidity and capital pressures that favor selling off the loans they originate, but loan sales undermine their monitoring incentives. A bank’s loan default history is a noisy measure of its past monitoring choices, which can serve as a reputation mechanism to incentivize current monitoring. In equilibrium, higher reputation banks monitor (weakly) more intensively; if retention is credible, they generally retain less of the loans they originate. Monitoring is difficult to sustain in periods with uncommonly large spikes in loan demand (“booms”), especially for low-reputation banks, which are more likely to accommodate boom demand and forgo monitoring.
2017
A regulatory enforcement action on banks for non-compliance with laws and regulations has an adverse reputational effect that potentially disincentivizes syndicate participants from cofinancing the loan. We formally argue that in such cases, the lead arranger must increase his share of the loan in order to make the loan sufficiently attractive to potential participants. We provide strong empirical evidence to support our theoretical argument, using hand-collected syndicated loan-level data and a sample of enforcement actions enacted from 2001 through 2010 on U.S. lead-syndicate lenders. These effects can be offset or lessened by including loan guarantees, performance pricing provisions, and covenants. JEL classification: D82; G21; G28
Group Lending and Endogenous Social Sanctions
2014
In recent years, microfinance institutions have expanded into group lending with individual liability, leaving out the joint liability clause which was an important feature in earlier lending contracts. Recent experimental evidence indicates that group lending may yield benefits, specifically lowering default rates, even in the absence of joint liability. In this paper, we develop a theoretical model where the public nature of group meetings means that borrowers have incentives to repay a group loan to safeguard their reputation. We show that the introduction of group loans with individual liability will cause sorting between joint liability and individual liability group loans. Specifically, borrowers who attach more importance to their reputation will select into individual liability loans, causing default rates and interest rates to rise for joint liability loans. The introduction of group loans with individual liability can even make joint liability loans infeasible in equilibrium.
Reputation, Trust and the Logic of Group Lending
SSRN Electronic Journal, 2000
This paper analyzes the interaction between the success of group lending institutions and the stock of social capital (modeled by the level of trust) in the community where the group lending programs are located. Agents play a finitely repeated "trust game" in parallel with a finitely repeated "microcredit game." There are two agent types: "regular" and "trustworthy," and these types are private information. Moral hazard problems are present in both games. The model shows that there are conditions under which the presence of trust as an equilibrium of the trust game can enhance the success of the group lending program. Similarly, there are conditions under which success of the group lending program can enhance the development of trust.
2013
Reputation concerns in credit markets restrain borrowers' temptations to take excessive risk. The strength of these concerns depends on the behavior of other borrowers, rendering the reputational discipline fragile and subject to breakdowns without obvious changes in economic fundamentals. Furthermore, at an aggregate level, breakdowns are clustered among borrowers who have intermediate and good reputations, magnifying otherwise small economic shocks.