AGENDA 4 THE RISK SHARING APPROACH 4 COSTLY STATE VERIFICATION 4 INCENTIVES TO REPAY 4 INCOMPLETE CONTRACTS 4 DISCRIMINATING AMONG BORROWERS
THE COMPLEXITY OF CONTINGENT CONTRACTS 4 Repayments (Additional loans) 4 Collateral 4 The borrower’s actions (investment)
THE STANDARD DEBT CONTRACT 4 definition: 4 repayment is independent of cash flows 4 If the cash flows are insufficient, all assets go to the lenders 4 If cash flows are insufficient, lenders get control of the firm
THE RISK SHARING APPROACH 4 Assume cash flows are risky but there is no asymmetric information 4 How is the optimal contract characterised? 4 For every cash flow, borrower and lender marginal utilities have to maintain a fixed ratio
COSTLY STATE VERIFICATION 4 Observation of the borrower’s cash flows is costly (auditing cost) 4 The contract can be designed so that depending on the repayment the borrower is audited or not. 4 Minimisation of the auditing costs leads to the Standard Debt Contract.
4 Recovery rates 4 No strategic default 4 Equilibrium:
Implications 4 Inefficient investment –Notice that a lower recovery rate on cash flows will lead to collateral based lending 4 Low legal enforcement (high borrower protection?) lead to lower levels of finance.
INCENTIVES TO REPAY 4 Cash flows observation is infinitely costly 4 The incentives to repay may come from the benefits of receiving funding in the future.
INCENTIVES TO REPAY: 4 BOLTON-SHARFSTEIN 4 SOVEREIGN DEBT
BOLTON-SHARFSTEIN(I) 4 Zero interest rates, risk neutral agents 4 A project may have a high or low non verifiable cash flow 4 In a one period contract, the borrower will pretend the low cash flow has obtained 4 As a consequence credit market would not exist
BOLTON-SHARFSTEIN(II) 4 In the two period case the lender may promise additional funding to the borrowers that have repaid and no funding to the defaulting ones 4 The incentives to repay for a successful firm are now :
BOLTON-SHARFSTEIN(III) 4 In the dynamic case, a market for loans may develop because the threat of termination may provide the right incentives 4 The bank promise to provide additional funding has to be credible
SOVEREIGN DEBT(I) 4 A simple model (Allen 1983) 4 The country’s profit are:
SOVEREIGN DEBT(II) 4 In an infinite horizon the present value of being denied credit by the borrower is:
SOVEREIGN DEBT(III) 4 Credit rationing? 4 Bullow Rogoff argument
INCOMPLETE CONTRACTS 4 EX ANTE DESIGN AND EX POST RENEGOTIATION 4 CASH FLOWS VS. PLEDGEABLE CAS H FLOWS
DISCRIMINATING AMONG BORROWERS 4 ASYMMETRIC INFORMATION AND MECHANISM DESIGN 4 COLLATERAL AND REPAYMENT 4 LOAN SIZE AND REPAYMENT