Foreign Lenders and the Real Sector

We develop a theory of the interaction between the entry of lenders and the real sector. The high liquidation skills of incumbent lenders render them too tough in terminating high-risk/return projects. Being "foreign" to the market, newcomers have lower ability to liquidate than incumbents. This makes them softer in liquidating high-risk/return projects but renders their funding more costly. We show that the entry of lenders and the share of high-risk/return projects can reinforce each other through firms' liquidation values. This interaction dampens the output impact of liquidity shocks. Hence, financial liberalization can enhance stability.