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 borrowers 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 borrowers 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.

REPAYMENTS

CASH FLOWS

DRAWBACKS
Is the audit threat credible? Should not renegotiation be introduced? Random auditing with high penalties may be more efficient

Legal enforcement

y R + P ( y 2 = y )( y y ) y y
( p , c )

Legal enforcement
Recovery rates ( p , c ) No strategic default R p y +c C Equilibrium: 2 pR + (2 p ) m R, c C ) = in(

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 :

y R + P ( y 2 = y )( y y ) y y

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 countrys profit are:

= f ( L) (2 r ) L + implying : f ' ( L) = (2 r ) +

SOVEREIGN DEBT(II)
In an infinite horizon the present value of being denied credit by the borrower is:

V ( L) = ( f ( L) (2 r ) L) +
t t =2

t =

incentives (2 r ) L V ( L) +

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