Debt Contract, Strategic Default, and Optimal Penalties with Judgement Errors (original) (raw)

Default and Punishment in General Equilibrium1

Econometrica, 2005

We extend the standard model of general equilibrium with incomplete markets to allow for default and punishment by thinking of assets as pools. The equilibrating variables include expected delivery rates, along with the usual prices of assets and commodities. By reinterpreting the variables, our model encompasses a broad range of adverse selection and signalling phenomena in a perfectly competitive, general equilibrium framework.

Optimal Debt Contracts under Costly Enforcement

RePEc: Research Papers in Economics, 2007

We consider a financing game with costly enforcement based on Townsend (1979), but where monitoring is non-contractible and allowed to be stochastic. We derive the optimal contract and show that it is debt. Moreover, we show that the optimal contract induces creditor leniency and strategic defaults on the equilibrium path, consistent with empirical evidence on repayment and monitoring behavior in credit markets.

Multiple Lenders, Strategic Default and the role of Debt Covenants

2010

This paper investigates the relationship between competition and contract design in capital markets subject to moral hazard. We consider the stylized representation of the capital market introduced by Holmstrom and Tirole (1997, 1998), and we explicitly model competition among investors as an extensive form game. Financial contracts are taken to be non-exclusive, which guarantees that entrepreneurs can trade with several investors at a time. In such a context, we provide a full characterization of the set of equilibrium allocations and we show that the features of market equilibria crucially depend on the financial contracts made available to financiers. If lenders make use of debt contracts only, the equilibrium outcome is always efficiently, and unique when the moral hazard problem is severe. Then, the aggregate of lenders earn monopoly profits. If covenants contingent on the project's cash-flow can be included in financial contracts, then every feasible allocations can be supported at equilibrium: market equilibria are indeterminate and Pareto-ranked. The introduction of institutional mechanisms which prevent borrowers from strategically defaulting on their loans can restore the competitive outcome as the unique equilibrium allocation.

Lending, Lying, and Costly Auditing

SSRN Electronic Journal, 2000

In this paper, we describe a bankruptcy game played in a pure-exchange, perfectly competitive economy, and establish the existence of competitive equilibria. The game admits of lying by borrowers and costly auditing by lenders. The equilibria are characterized by (endogenously determined) equilibrium probabilities of default, loan quantities, interest rates, and default risk premia, and by equilibria simultaneously determined in risk-free debt markets. We find that the optimal debt contract is the standard debt contract, and that the risk-free debt market may be inactive, as all parties may strictly prefer risky debt contracts to risk-free debt.

A Model of Strategic Default with Competing Lenders∗

2003

I study a model with strategic default that could be used to analyze international financial transactions in a multicountry model, where there is a set of financial intermediaries operating internationally and a set of local lenders operating at country level. Due to the presence of a transaction cost on cross border flows, the model generates Nash equilibria of a Cournot game such that financial intermediaries and local lenders simultaneously lend to the same local entrepreneurs. When borrowers have low wealth, a "no-default constraint" is binding and there exists equilibria in which total investment is greater than the level achieved when lending is only provided by a single intermediary. However, contrary to standard models with strategic default, direct transfers may fail to increase total investment and a tax on international financial transactions may be welfare improving.

Collateral or utility penalties?

International Journal of Economic Theory, 2007

In a two-period economy with incomplete markets and possibility of default we consider the two classical ways to enforce the honor of financial commitments: by using utility penalties and by using collateral requirements that borrowers have to fulfill. Firstly, we prove that any equilibrium in an economy with collateral requirements is also equilibrium in a non-collateralized economy where each agent is penalized (rewarded) in his utility if his delivery rate is lower (greater) than the payment rate of the financial market. Secondly, we prove the converse: any equilibrium in an economy with utility penalties is also equilibrium in a collateralized economy. For this to be true the payoff function and initial endowments of the agents must be modified in a quite natural way. Finally, we prove that the equilibrium in the economy with collateral requirements attains the same welfare as in the new economy with utility penalties.

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.

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.

Indeterminacy of competitive equilibrium with risk of default

2009

Abstract: We prove indeterminacy of competitive equilibrium in sequential economies, where limited commitment requires the endogenous determination of solvency constraints preventing debt repudiation (Alvarez and Jermann (2000)). In particular, we show that, for any arbitrary value of social welfare in between autarchy and (constrained) optimality, there exists an equilibrium attaining that value. Our method consists in restoring Welfare Theorems for a weak notion of (constrained) optimality. The latter, inspired by Malinvaud ( ...