THE BORROWER-LENDER RELATIONSHIP

AGENDA

THE RISK SHARING APPROACH COSTLY STATE VERIFICATION INCENTIVES TO REPAY INCOMPLETE CONTRACTS DISCRIMINATING AMONG

BORROWERS

THE COMPLEXITY OF CONTINGENT CONTRACTS Repayments (Additional loans) Collateral The borrower’s actions (investment)

THE STANDARD DEBT CONTRACT definition: repayment is independent of cash flows If the cash flows are insufficient, all assets

go to the lenders If cash flows are insufficient, lenders get

control of the firm

THE RISK SHARING APPROACH Assume cash flows are risky but

there is no asymmetric information How is the optimal contract

characterised? For every cash flow, borrower and

lender marginal utilities have to maintain a fixed ratio

COSTLY STATE VERIFICATION Observation of the borrower’s cash flows is

costly (auditing cost) The contract can be designed so that

depending on the repayment the borrower is audited or not.

Minimisation of the auditing costs leads to the Standard Debt Contract.

CASH FLOWS

REPAYMENTS

DRAWBACKS

Is the audit threat credible? Should not renegotiation be introduced?

Random auditing with high penalties may be more efficient

Legal enforcement

yyyyyyPRy )()( 2

),( cp

Legal enforcement

Recovery rates No strategic default

Equilibrium:

),( cp

CyR cp

),min()1(1 CRppR c

Implications

Inefficient investment– Notice that a lower recovery rate on cash flows

will lead to collateral based lending

Low legal enforcement (high borrower protection?) lead to lower levels of finance.

INCENTIVES TO REPAY

Cash flows observation is infinitely costly The incentives to repay may come from the

benefits of receiving funding in the future.

INCENTIVES TO REPAY:

BOLTON-SHARFSTEIN SOVEREIGN DEBT

BOLTON-SHARFSTEIN(I)

Zero interest rates, risk neutral agents A project may have a high or low non

verifiable cash flow In a one period contract, the borrower will

pretend the low cash flow has obtained As a consequence credit market would not

exist

BOLTON-SHARFSTEIN(II)

In the two period case the lender may promise additional funding to the borrowers that have repaid and no funding to the defaulting ones

The incentives to repay for a successful firm are now :

yyyyyyPRy )()( 2

BOLTON-SHARFSTEIN(III)

In the dynamic case, a market for loans may develop because the threat of termination may provide the right incentives

The bank promise to provide additional funding has to be credible

SOVEREIGN DEBT(I)

A simple model (Allen 1983) The country’s profit are:

)1()('

:

)1()(

rLf

implying

LrLf

SOVEREIGN DEBT(II)

In an infinite horizon the present value of being denied credit by the borrower is:

)()1(

))1()(()(1

LVLr

incentives

LrLfLVt

t

t

SOVEREIGN DEBT(III)

Credit rationing? Bullow Rogoff argument

INCOMPLETE CONTRACTS

EX ANTE DESIGN AND EX POST RENEGOTIATION

CASH FLOWS VS. PLEDGEABLE CAS H FLOWS

DISCRIMINATING AMONG BORROWERS ASYMMETRIC INFORMATION AND

MECHANISM DESIGN COLLATERAL AND REPAYMENT LOAN SIZE AND REPAYMENT