Optimal Debt Contracts under Costly Enforcement (original) (raw)

Debt Contract, Strategic Default, and Optimal Penalties with Judgement Errors

Annals of Economics and Finance

We characterize the competitive equilibrium on the credit market when borrowers can strategically default. We assume that the audit is subject of errors of the two types and that lenders cannot commit ex-ante. We determine the penalty, the loan rate, the audit and strategic default probabilities. Borrowers' limited liability is endogenous when "judicial errors" exist, strategic default appears at equilibrium depending on the borrowers' absolute risk aversion. We show that at equilibrium loan contracts exhibit a penalty such that borrowers never strategically default. This is true with IARA and CARA utility function. Finally, we show that with DARA, strategic default may exist.

Costly Monitoring, Dynamic Incentives, and Default

2010

We study optimal dynamic financial contracts between a lender and a borrower in the presence of costly state verification. The efficient contract is such that (1) interim monitoring can prevent future ineffi-cient liquidation of investment projects that are due to informational asymmetries and (2) two levels of bankruptcy can be distinguished, one that leads to monitoring and the other that leads to liquidation. 1

Optimal contracts when enforcement is a decision variable: A comment. Authors' reply

Econometrica, 2003

JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range of content in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new forms of scholarship. For more information about JSTOR, please contact support@jstor.org. This paper analyzes choice-theoretic costly enforcement in an intertemporal contracting model with a differentially informed investor and entrepreneur. An intertemporal contract is modeled as a mechanism in which there is limited commitment to payment and enforcement decisions. The goal of the analysis is to characterize the effect of choice-theoretic costly enforcement on the structure of optimal contracts. The paper shows that simple debt is the optimal contract when commitment is limited and costly enforcement is a decision variable (Theorem 1). In contrast, stochastic contracts are optimal when agents can commit to the ex-ante optimal decisions (Theorem 2). The paper also shows that the costly state verification model can be viewed as a reduced form of an enforcement model in which agents choose payments and strategies as part of a perfect Bayesian Nash equilibrium.

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.

Default and efficient debt markets

Journal of Mathematical Economics, 2002

We examine the nature of debt contracts when repayment of debt cannot be fully enforced. We study outcomes an infinite-horizon economy in which some individuals have access to a productive, intertemporal technology. Individuals without access to the technology must lend their savings to the rest. Borrowers can default on their debt at any time: lenders can capture a fraction of their investment incomes. Borrowers who default stand to lose the right to borrow in the future. These constitute the penalties of capture and exclusion.

Debt Enforcement and Relational Contracting

2011

We examine how third-party debt enforcement affects the emergence and performance of relational contracts in credit markets. We implement an experiment with finitely repeated credit relationships in which borrowers can default. In our weak enforcement treatment defaulting borrowers can keep their funds invested. In our strong enforcement treatment defaulting borrowers have to liquidate their investment. Under weak enforcement fewer relationships emerge in which loans are extended and repaid. When such relationships do emerge they exhibit a lower credit volume than under strong enforcement. These findings suggest that relational contracting in credit markets requires a minimum standard of thirdparty debt enforcement.

The welfare implications of costly monitoring in the credit market

The Economic Journal, 1994

Various explanations of credit rationing are based upon asymmetries of information. It has been suggested that rationing represents a sub-optimal allocation. We examine this claim using a general equilibrium model with hidden information and costly monitoring. If credit is rationed the equilibrium is indeed sub-optimal yet social efficiency requires that credit be more tightly rationed. The reason is that loan applicants are charged for the average expected monitoring costs whereas efficiency dictates that they should bear the marginal monitoring costs which includes the effect of a rise in the interest rate on the total number of defaulting loans. A similar inefficiency can occur even in the absence of rationing and may require the introduction of rationing to correct it.

Lending with costly enforcement of repayment and potential fraud

Journal of Banking & Finance, 1986

If contracts are costlessly enforcible then insolvency is the only reason for nonrepayment of loans. While some models have examined the borrower's incentive to repay, it has typically been assumed that the penalty suffered by a debtor in default is imposed automatically and without cost to the lender. If in fact invoking a penalty is costly, Pareto-improving loans may be dynamically inconsistent not because of the absence of a sufficiently harsh penalty for default, but because the lender has no incentive actually to implement the penalty in the event of default. In such situations infinitelylived institutions can emerge as banking intermediaries between lenders and borrowers. These institutions, repeatedly involved in lending, have an incentive to enforce contracts that individual lenders lack. They can consequently sustain more lending. For their reputations as enforcers of contracts to have value requires that banks earn strictly positive profits. Maintaining the value of bank equity also provides an incentive for bank owners to invest deposits rather than to use these funds fraudulently. Because of the supernormal profits that banks must earn, an equilibrium that is sustained by bank reputation will not replicate an equilibrium in which loan repayment is automatically guaranteed.

A Stochastic Model of Optimal Debt Management and Bankruptcy

SIAM Journal on Financial Mathematics, 2017

A problem of optimal debt management is modeled as a noncooperative game between a borrower and a pool of lenders, in infinite time horizon with exponential discount. The yearly income of the borrower is governed by a stochastic process. When the debt-toincome ratio x(t) reaches a given size x * , bankruptcy instantly occurs. The interest rate charged by the risk-neutral lenders is precisely determined in order to compensate for this possible loss of their investment. For a given bankruptcy threshold x * , existence and properties of optimal feedback strategies for the borrower are studied, in a stochastic framework as well as in a limit deterministic setting. The paper also analyzes how the expected total cost to the borrower changes, depending on different values of x * .

Investor protection and optimal contracts under risk aversion and costly state verification

2013

We study financial contracting in a model encompassing costly state verification, risk aversion and imperfect investor protection. We characterize optimal contracts with special emphasis on repayment functions that are continuous on the firm's returns and provide a well specified condition for such contracts to take the form of standard debt. Moreover, we show that for some popular specifications of preferences, standard debt can be optimal only if investor protection is imperfect. Our comparative statics exercises demonstrate that, as long as the contract is continuous, the cost of funds and the probability of bankruptcy are decreasing in the level of investor protection, a result that can be extended to a dynamic setting. In a specific parametrization of the problem, we show that moderate changes in the level of investor protection can have substantial quantitative effects on the terms of the optimal contract and on the borrower's welfare. Finally, we study the relationship between investor protection and leverage and consider the consequences of implementing standard debt contracts when optimality conditions are not satisfied.