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.
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( y2  y)( y  y)  y  y
( p , c )
Legal enforcement
 Recovery rates
( p , c )
 No strategic default
R   p y  c C
 Equilibrium:
1  pR  (1  p) min( R, c 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 :
y  R  P( y2  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 country’s profit are:
  f ( L)  (1  r ) L
implying :
f ' ( L)  (1  r )
SOVEREIGN DEBT(II)
 In an infinite horizon the present value of
being denied credit by the borrower is:
t 
V ( L)    ( f ( L)  (1  r ) L)
t
t 1
incentives
(1  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