A political economy theory of the soft budget constraint

Why do soft budget constraints exist and persist? In this paper we argue that the prevalence of soft budget constraints can be best explained by the political desirability of softness. We develop an infinite horizon political economy model where neither democratic nor autocratic politicians can commit to policies that are not ex post optimal. We show that because of the dynamic commitment problem inherent in the soft budget constraint, politicians can in essence commit to make transfers to entrepreneurs which otherwise they would not be able to do. This encourages such entrepreneurs to support them politically. Though the soft budget constraint may induce economic inefficiency, it may be politically rational because it influences the probability of political survival. In consequence, even when information is complete, politicians may fund bad projects which they anticipate they will have to bail out in the future. We show that, maybe somewhat surprisingly, dictators who are less likely to lose power, are more likely to use the soft budget constraint as a strategy to gain political support.     

The Impact of Liquidity Constraints on Bank Lending Policy

This paper examines banks' provision of liquidity to depositors and provision of loans. The problem identified is that banks may not be able to provide new funds for borrowers who are short of cash, because either the return on investments is poor, or because depositors withdraw more funds than expected. Banks subject to liquidity shortages may ration loans to good borrowers. This problem is shown to depend upon the nature of the deposit contract and banks' inability to issue subordinated deposits. State contingent renegotiation of loans and matching of the duration of project returns and investment needs mitigates the problem.     

Is centralization a solution to the soft budget constraint problem?

This paper focuses on the centralization program implemented in Israel in 2004 to analyze whether the administrative subordination of municipalities is an effective policy to deal with problems related to soft-budget constraint of lower level governments. The results consistently show, for different specifications and samples of municipalities, that this program brought a substantial decrease of municipalities’ expenditures (mostly because of decreases in salary payments), and an increase of local property tax collection. Our analysis shows that all of the fiscal impact of the program is due to the appointment of an accountant that reports directly to the central government, a relatively mild form of administrative subordination. In contrast, more intrusive forms of subordination, like the central imposition of a recovery program, do not result in any substantial improvement of municipalities’ fiscal situation. This leads us to conclude that a mild form of administrative subordination is an effective tool to cope with problems related to soft-budget constraints, whereas political subordination is not an effective tool to reach that goal.     

Privatization and Its Benefits: Theory and Evidence

Privatization has been a key component of structural reformprograms in both developed and developing economies. The aimof such programs is to achieve higher microeconomic efficiencyand foster economic growth, as well as reduce public sectorborrowing requirements through the elimination of unnecessarysubsidies. Microeconomic theory tells us that incentive andcontracting problems create inefficiencies due to public ownership,given that managers of state-owned enterprises pursue objectivesthat differ from those of private firms (political view) andface less monitoring (management view). Not only are the managers'objectives distorted, but the budget constraints they face arealso softened. The soft-budget constraint emerges from the factthat bankruptcy is not a credible threat to public managers,for it is in the central government's own interest to bail themout in case of financial distress. Empirical evidence showsa robust corroboration of theoretical implications: privatizationincreases profitability and efficiency in both competitive andmonopolistic sectors. Full privatization has a greater impactthan partial privatization and monopolistic sectors show anincrease in profitability that is above the component explainedby increases in productivity, which reflects their market power.From the macroeconomic perspective, no conclusive evidence canbe drawn, but the trends are favorable. (JEL D21, D61, D62,E65)     

Do liquidity constraints generate excess sensitivity in consumption? New evidence from a sample of post-bankruptcy households

Previous work linking liquidity constraints to excessive consumption sensitivity have used household level information on wealth and assets to split the sample into households that are likely to be constrained from those with access to credit and liquidity. In this paper, we use the sample splitting methods of previous authors but refine the criteria by using direct information on whether the household filed for bankruptcy in the last 10 years. Legally, a flag can appear on a bankruptcy filer’s credit report for up to 10 years after bankruptcy. This bankruptcy flag affects an individual’s credit score, and therefore the individual’s access to credit, which may make post-bankruptcy consumers liquidity constrained. Our results indicate that post-bankruptcy consumers exhibit excess sensitivity likely due to the bankruptcy flag. Consistency checks confirm that the source of sensitivity is due to liquidity constraints and not other observationally equivalent behavior.     

Credit quality and technical efficiency in banking

We estimate banks’ technical efficiency using directional distance functions, a generalization of the radial distance functions that allow us to credit banks for their efforts to increase outputs and decrease resource use and bad loans. We find that once bad loans are considered, banks’ efficiency increases significantly. In addition, omitting bad loans may result in the underestimation of the performance of good credit quality banks. These results suggest that a significant aspect of banking production, credit quality, needs to be considered when evaluating banks’ performances for regulatory purposes.     

A Theory of Conflicts of Interest in Banking Relationships

Abstract

This paper highlights a dark side of banking relationships by elucidating the conditions under which a pre-existing relationship between a lending bank and a borrower can be detrimental to positive valuation effects of loan announcements. The effect of a pre-existing relationship is more likely to be negative when the pre-existing loans are large and firms' screening costs are low. A theoretical model shows that loan announcement's positive effect on borrowers' value due to the standard information advantage can be more than offset by the bank's conflict of interest when the bank's asset quality reputation is poor, i.e. when the probability of the bank holding a bad loan is large.     

Leaving your tailings behind: Environmental bonds,bankruptcy and waste cleanup

This paper studies the impacts of an environmental bond, which fully covers waste cleanup costs, on a mining firm's optimal actions over the full life cycle of a mine, when bankruptcy may shift cleanup costs to the government. A firm's stochastic optimal control problem is described by an HJB equation with the resource price modelled as an Ito process. A theoretical result shows that under certain assumptions, an environmental bond can ensure that the option to declare bankruptcy has no impact on the firm's optimal actions. A numerical solution is implemented for a hypothetical copper mine using two different models of bankruptcy risk. Numerical results show that when bankruptcy is an option and no bond is required, the firm produces too much waste relative to a benchmark case, resulting in an efficiency loss and a cleanup liability imposed on government. In the presence of bankruptcy risk, a bond ensures that the firm acts optimally and no efficiency loss is imposed on society.     

Bad loans,soft budget constraints and the political economy of financial market reform in transition economies

Financial market imperfections and especially the bad debt problem are among the most important factors impeding economic restructuring in transition economies. This paper analyses the implications of non-performing loans for the lending policy of banks and for the ensuing allocation of credit. It is shown that a lending bias exists in favour of old debtors, which not only impedes structural change but may also counteract policies intended to harden budget constraints and to promote restructuring. The paper also discusses from a political economy perspective, why despite these negative implications financial market reforms were not pursued more forcefully in most countries.     

On the Co-existence of Conventions

Recent stochastic evolutionary models have shown that the most likely outcome when the probability of a mutation is sufficiently small is coordination on the risk-dominant strategy rather than on the payoff-dominant one. This paper looks at the consequences of player movement between locations when there are constraints which limit the number of agents who can reside at each location. If the constraints are tight then the risk-dominance result continues to hold. However, we show that when sufficient movement is possible, the most likely outcome involves a mixed state in which agents at different locations coordinate on different strategies. In the asymmetric case, it is the location with the tighter constraint that coordinates on the payoff-dominant strategy. Journal of Economic Literature Classification Numbers: C72, C73, D83.     

Herding and bank runs

Traditional models of bank runs do not allow for herding effects, because in these models withdrawal decisions are assumed to be made simultaneously. I extend the banking model to allow a depositor to choose his withdrawal time. When he withdraws depends on his consumption type (patient or impatient), his private, noisy signal about the quality of the bank's portfolio, and the withdrawal histories of the other depositors. Some of these runs are efficient in that the bank is liquidated before the portfolio worsens. Others are not efficient; these are cases in which the herd is misled.     

Asymmetric Information and the Russian Individual Savings Market

The article considers the influence of informational imperfections on the performance of the Russian financial market. The focus is on the individual savings market, which exhibits inefficiencies, including those associated with the market power of a dominant agent—Sberbank. Reinforcement of Sberbank's dominance on the market in the period 1994‐98 (before the August default combined with financial crisis) is explained as a consequence of asymmetric information about the probability of bankruptcy of a new bank. Under asymmetric information a new private bank has to provide specific quality signals in order to attract depositors. Two major lines of inquiry are the criteria for choosing forms of savings, including that of a bank in which to deposit money, by Russian citizens, and banks' advertising strategies to confirm the factual risk of default. Within the conceptual framework of a game with separating equilibrium, we analyse the behaviour of the agents on both supply and demand sides in the market. We find that there is evidence of using advertising as a tool of quality signalling at a certain phase of the Russian individual savings market's development.     

REGULATORY FORBEARANCE AND DEPOSITOR MARKET DISCIPLINE: EVIDENCE FROM SAVINGS BANKS IN KOREA

This paper investigates whether regulatory forbearance for savings banks in Korea affects the market discipline of depositors using data from 2000 to 2010, which are characterized by a series of exits of savings banks. We find that depositors' sensitivity to the savings banks' asset quality decreases when there is regulatory forbearance for failing savings banks. This forbearance effect is also observed in the behavior of the depositors of the neighboring savings banks in the same business area. These results suggest that regulatory forbearance may cause depositors to misjudge bank risks, increasing the expected costs of bank failure. (JEL G21, G28)     

Investment credit and child labour

It is generally assumed that credit has a positive effect on children's schooling among poor households. This article shows that need not be the case when households obtain credit for investment purposes. In fact, investment loans may not have any effect on the likelihood of schooling for children who work in their family business. Our estimates confirm that this is the case; credit used to finance investments has no effect on the odds of schooling for employed children. This may be because investment loans increase children's labour productivity, which in turn increases the opportunity cost of schooling. The results of this study suggest that improving access to credit may not, by itself, constitute a solution to the problem of child labour in developing countries.     

Religiosity versus rationality: Depositor behavior in Islamic and conventional banks

This study investigates the behavioral aspects of Islamic bank depositors in a dual banking system. By categorizing depositors into groups based on the amount of their deposited funds, we estimate the responses of these groups to interest rate changes. We take the findings of conventional banks as a comparative baseline and investigate the extent to which the changes in different Islamic depositor groups differ from conventional depositor groups. The findings show that depositors in both Islamic and conventional banks respond to interest rate changes. The analysis indicates that Islamic bank depositors are more responsive when their deposit sizes are larger. When Islamic bank depositors’ opportunity costs rise due to a rise in the interest rate, they do not hesitate to withdraw deposits. The relation between interest rate changes and deposits is more robust in Islamic banks than in conventional banks.     

Mechanism design with a liquidity constrained buyer: The 2×2 case

This paper studies the implications of buyers' liquidity constraints for the optimal selling strategy. The possibility that a buyer faces a binding liquidity constraint affects the seller's strategy in a nontrivial way. Specifically, when a seller has one unit of a good to sell to a buyer with a quasilinear utility function, the `no-haggling' result indicates that textbook monopoly pricing is optimal, absent liquidity constraints. Introducing a potentially binding liquidity constraint vitiates the no-haggling result, and can make it strictly beneficial for the seller to use nonlinear pricing, to commit to a declining price sequence, or to require the buyer to post a cash bond.     

A note on capital markets and bankruptcy constraints in contracting

This note considers the extent to which state-contingent bankruptcy constraints in a standard contracting problem with adverse selection can be mitigated by a risk-neutral third party. It shows that if payoffs of principal and agent are quasi-linear, the third party can only affect the constraints if it has complete information about the agent's type — observing a correlated signal is not enough.     

The role of state enterprises in the transition from command to market economies

In transition from command to market economies total privatization has proved to be impossible to achieve, and a substantial part of large enterprises are likely to remain in full or partial state ownership. Hasty privatization has in many cases even proved to be destructive. There is a need to reconsider the basic approach to transition. Contrary to conventional wisdom prevailing in mainstream economics state-owned enterprises (SOEs) are not necessarily inferior to private firms in economic efficiency. J. Kornai's soft-budget constraint is reconsidered. Two models are suggested under which SOEs may prove to be viable in the long run and serve to promote a smoother physical transition. Under Model One (which is the general case) SOEs are largely separated from the state and operate on the basis of profit maximization. Under Model Two (which applies to certain industries) different objective functions are chosen for purposes of economic efficiency. Finally, preserving SOEs is seen as an alternative means of reducing inequitable income distribution at the source where primary incomes are created.     

Information and credit access: using bankruptcy as a signal

Legally, a bankruptcy flag can appear on an individual's credit report for up to 10 years after the filing. The flag affects an individual's credit score, and in turn, an individual's access to credit. In this article, we investigate how the bankruptcy flag affects access to credit along three dimensions–loan acceptance, the price of the loan as is determined by the interest rate, and the amount of credit the household receives. Using the Panel Study of Income Dynamics and the Survey of Consumer Finances, we estimate a series of two-stage models corrected for sample selection and adjusted to account for the household's level of creditworthiness. We find that the bankruptcy flag increases the probability of being denied access to a loan. The flag also increases interest rates for unsecured loans and lowers the credit limits available to households. The findings have important implications with respect to current bankruptcy code and the impact that information, such as the bankruptcy flag, can have on the efficiency of the credit markets.     

Causal Effect of Credit Guarantees for Small- and Medium-Sized Enterprises: Evidence from Italy

We evaluate the effectiveness of a partial credit guarantee program, implemented in a large Italian region, that aimed to improve the access to credit of small and medium enterprises. Using unique microdata from a broad set of firms, we show that the policy increased the long-term loans for beneficiary firms, while the total volume of bank loans was unaffected. Furthermore, targeted firms benefited from a substantial decrease in interest rates. However, there is some evidence that firms are more likely to default as a consequence of the treatment. Conversely, the results do not point to any significant effect on investments.