Bargaining power and enforcement in credit markets

In a credit market with enforcement constraints, we study the effects of a change in the outside options of a potential defaulter on the terms of the credit contract, as well as on borrower payoffs. The results crucially depend on the allocation of “bargaining power” between the borrower and the lender. We prove that there is a crucial threshold of relative weights such that if the borrower has power that exceeds this threshold, her expected utility must go up whenever her outside options come down. But if the borrower has less power than this threshold, her expected payoff must come down with her outside options. In the former case a deterioration in outside options brought about, say, by better enforcement, must create a Lorenz improvement in state-contingent consumption. In particular, borrower consumption rises in all “bad” states in which loans are taken. In the latter case, in contrast, the borrower's consumption must decline, at least for all the bad states. These disparate findings within a single model permit us to interpret existing literature on credit markets in a unified way.     

A dynamic model of unsecured credit

We study the terms of credit in a competitive market in which sellers (lenders) are willing to repeatedly finance the purchases of buyers (borrowers) by engaging in a credit relationship. The key frictions are: (i) the lender cannot observe the borrower?s ability to repay a loan; (ii) the borrower cannot commit to any long-term contract; (iii) it is costly for the lender to contact a borrower and to walk away from a contract; and (iv) transactions within each credit relationship are not publicly observable. The lender?s optimal contract has two key properties: delayed settlement and debt forgiveness. Finally, we study the impact of changes in the initial cost of lending on the contract terms.     

Strategic interaction in undeveloped credit markets

This paper studies the strategic interaction between informal and formal lenders in undeveloped credit markets. In a model with adverse selection, loan seniority, market power, and differences in the cost of lending, it is shown that under general conditions a co-funding equilibrium will be a Nash outcome of the game. We demonstrate that a collateral requirement in connection with formal loans always generates a new co-funding equilibrium in which both lenders earn higher profits. A government subsidy to the formal lender may have the opposite effect. We relate our results to existing empirical evidence and the emerging discussion of how to best ensure financial viability and outreach of microfinance institutions.     

Regulating Exclusion from Financial Markets

We study optimal enforcement in credit markets in which the only threat facing a defaulting borrower is restricted access to financial markets. We solve for the optimal level of exclusion, and link it to observed institutional arrangements. Regulation in this environment must accomplish two objectives. First, it must prevent borrowers from defaulting on one bank and transferring their resources to another bank. Second, and less obviously, it must give banks the incentive to make sizeable loans, and to honour their promises of future credit. We establish that the optimal regulation resembles observed laws governing default on debt. Moreover, if debtors have the right to a "fresh start" after bankruptcy then this must be balanced by enforceable provisions against fraudulent conveyance. Our optimal regulation is robust, in that it can be implemented in a way that does not require the regulator to have information about either the borrower or lender. Our results isolate the way in which specific institutions surrounding bankruptcy–namely rules governing asset garnishment and fraudulent conveyances–support loan markets in which borrowers have no collateral.     

Financial Globalization,Social Exclusion and Financial Crisis

This paper suggests one set of mechanisms that ties financial globalization processes to local dynamics of financial inclusion or exclusion. Specifically, this paper explores the worldwide reconsideration of financial firms’ strategies that has accompanied financial globalization. It is shown that the neoliberal and asymmetric‐information approaches to credit markets and financial crises in developing economies overlook these dimensions of financial globalization because of their tendency to focus on representative credit markets. Banks’ strategic shift has led to the global homogenization and stratification of financial practices—and this in turn has been a key driver of processes of financial exclusion. Financial exclusion then involves bifurcation within financial markets, so that different markets serve different portions of the household and business population. This analysis suggests a reconstruction of Minsky’s microfoundational model of the origins of financial fragility and crisis, which shifts from Minsky’s emphasis on a representative borrower–lender relationship to a situation of borrower–lender relationships in bifurcated markets.     

Tax Competition, Capital Mobility, and Public Good Provision Within a Trading Block

The authors examine a two–country general–equilibrium model of a two–country trading block where governments through tax policies attract mobile capital and provide an imported public consumption good. Within this framework the authors examine, among other things, how preferences over the public good and the size (population) of a country affect the Nash or cooperative equilibrium values of income tax rates in the two countries. The analysis identifies sufficient conditions under which (i) the Nash/cooperative equilibrium income tax rates are strategic substitutes or complements, and (ii) the Nash equilibrium income tax rates may be greater than the cooperative rates.     

The supply- and demand-side impacts of credit market information

We utilize a unique pair of experiments to isolate the ways in which reductions in asymmetric information alter credit market outcomes. A Guatemalan microfinance lender gradually started using a credit bureau across its branches without letting borrowers know about it. One year later, we ran a large randomized credit information course that described the existence and workings of the bureau to the clients of this lender. This pairing of natural and randomized experiments allows us to separately identify how new information enters on the supply and the demand sides of the market. Our results indicate that the credit bureau generated large efficiency gains for the lender, and that these gains were augmented when borrowers understood the rules of the game. The credit bureau rewarded good borrowers but penalized weaker ones, increasing economic differentiation.     

Lender deception as a response to moral hazard

The paper considers a principal–agent relationship between a borrower and lender based on a model from Bowles (Microeconomics: behavior, institutions, & evolution. Princeton University Press, Princeton, 2003). It expands the model by incorporating borrower collateral as an exogenous variable to partly assuage lender concerns about excessive risk, and a theory of lender deception is then developed. Deception is posited as a costly activity that effectively makes fraud undetectable and extracts the borrower’s economic rent arising from moral hazard despite the presence of third-party enforcement and borrower collateral. We identify under what conditions a lender may have sufficient incentives for employing deception and to what extent they would employ it. The likelihood of, and outcomes from, deception are compared between monopoly lenders those in competitive markets. The model suggests that competitive lenders have more incentive to deceive than a monopoly lender facing the same borrower.     

R&D INVESTMENT, CREDIT RATIONING AND SAMPLE SELECTION

We study whether R&D‐intensive firms are liquidity constrained, by modelling their antecedent decision to apply for credit. This sample selection issue is relevant when studying a borrower–lender relationship, as the same factors can influence the decisions of both parties. We find firms with no or low R&D intensity to be less likely to request extra funds. When they do, we observe a higher probability of being denied credit. Such a relationship is not supported by evidence from the R&D‐intensive firms. Thus, our findings lend support to the notion of credit constraints being severe only for a sub‐sample of innovative firms. Furthermore, the results suggest that the way in which the R&D activity is organized may differentially affect a firm's probability of being credit constrained.     

SCREENING AS A UNIFIED THEORY OF DELINQUENCY,RENEGOTIATION, AND BANKRUPTCY

We propose a parsimonious model with adverse selection where delinquency, renegotiation, and bankruptcy all occur in equilibrium as a result of a simple screening mechanism. A borrower has private information about her endowment, and a lender uses random contracts to screen different types of borrowers. In equilibrium, some borrowers choose not to repay and thus become delinquent. The lender renegotiates with some delinquent borrowers. In the absence of renegotiation, delinquency leads to bankruptcy. Applied to mortgage restructuring, our mechanism generates amplification of house‐price shocks through foreclosure spillovers. We also show that government intervention aimed at limiting foreclosures may have unintended consequences.     

The impact of public ownership in the lending sector

We examine the effects of increased government ownership of suppliers in the lending sector, which induces increased concern with total welfare and reduced concern with profit. Such increased ownership of a lender can have unanticipated effects. For instance, it can increase lender profit. Furthermore, borrower welfare often declines as government ownership increases in a lender with a relatively limited ability to discern the true quality of borrowers’ projects. In addition, there are settings in which increased government ownership of a lender has no impact on either lender profit or borrower welfare.     

Adverse selection as an explanation of credit rationing and different lender types

An adverse selection model is utilized to demonstrate that informational asymmetry may make it wealth optimal for the financial intermediary (FI) to credit ration and to rationalize the existence of different lenders in the credit market. The crucial assumption is that borrowers differ in their tolerance for a lender-imposed default penalty, the severity of which also varies with the lender. The credit rationing portion proves that the FI will: 1) be forced by a binding regulatory constraint to overinvest in capital; 2) ration its worst risk class borrowers; 3) establish its optimal loan interest rate on the basis of the average quality of its loans and the interest rate elasticity of the borrower demand in its best risk category; and 4) decrease the total loan volume and increase the loan interest rate due to an increase in the capital requirement, but the effect on the default risk quality of its loan portfolio is ambiguous. The existence result is that if a lender has a high default penalty, he can charge a lower rate and attract only “good” borrowers, i.e., heterogeneous lender types encourage the screening of borrowers and vice versa.     

Bilateral transfers and lending in international environmental cooperation

The paper analyzes environmental lending and transfers in a two country general equilibrium framework. The lender country chooses specific environmental investments which it finances in the neighbour country on the basis of the returns they generate for the lender. The gains from this kind of international environmental financing are illustrated with a numerical calibration of the model showing that the gains to the lender country may be fairly sizable in relation to the expenditure directed currently towards environmental protection. These gains, however, essentially depend on the terms of the environmental financing. We also find that debt-for-nature swaps do not in general produce efficient environmental protection if applied uniformly in international environmental financing.     

Capital income taxation in a growing world economy

This paper deals with dynamic adjustment in large economies to changes in the rate of capital income taxation or in the rate of investment tax credit in one country. The framework applied in the paper is a continuous-time, overlapping generations model with two countries. It features population growth and debt non-neutrality. We address impact and steady state effects of capital income tax and investment subsidy changes in the home country on consumption per capita, the capital intensity, and the per capita net foreign asset position in both countries. We also briefly consider individual welfare consequences of these policies.     

Public-private partnerships in micro-finance: Should NGO involvement be restricted?

This paper examines public–private partnerships in micro-finance, whereby NGOs can help in channelizing credit to the poor, both in borrower selection, as well as in project implementation. We argue that a distortion may arise out of the fact that the private partner, i.e. the NGO, is a motivated agent. We find that whenever the project is neither too productive, nor too unproductive, reducing such distortion requires unbundling borrower selection and project implementation, with the NGO being involved in borrower selection only. Further, we compare and contrast two alternative credit delivery mechanisms, the linkage mechanism (which is the focus of this paper), with the ‘Grameen’ one.     

Collateralized Debt as the Optimal Contract

In a multiple-good risk-sharing environment with ex post private information, conditions are found under which collateralized debt is the optimal contract. The necessary and sufficient condition is that the borrower values the collateral good more highly than does the lender; otherwise the optimal contract does not resemble debt. Limited collateral can give rise to an endogenous borrowing constraint, driving a further wedge between the intertemporal marginal rates of substitution of the borrower and the lender. Journal of Economic Literature Classification Numbers: D82, G10.     

Taxing multinationals: The scope for enforcement cooperation

Policymakers seeking to raise more tax revenues from multinational enterprises have two alternatives: to raise tax rates or to devote more resources to improve tax compliance. Tougher tax enforcement increases the cost of profit shifting, and thus mitigates tax competition. We present a tax-competition model with two policy instruments (the corporate tax rate and the tightness of tax enforcement). In line with the Organisation for Economic Cooperation and Development's Base Erosion and Profit Shifting project, we analyze the scope for enforcement cooperation among asymmetric countries, considering that taxes are set noncooperatively. We show that the low-tax country may fail to cooperate if asymmetry is large enough and that tax havens would never agree to cooperate. Then we identify two drivers for enforcement cooperation. The first driver of cooperation is the complementarity of enforcement actions across countries. This is because the efficiency loss from enforcement dispersion is greater under complementarity. The second driver of cooperation is tax leadership by the high-tax country, which acts as a level-playing field in the tax competition and reduces the extent of disagreement on enforcement.     

The Financing of Foreign Aid and Welfare: Income Versus Consumption Tax

Empirical evidence shows that developed countries use income or consumption taxes to generate tax revenue, of which they transfer a certain fraction as aid to less developed countries. This paper constructs a two-country general equilibrium trade model that takes into account these realities, and examines the terms of trade, employment and welfare effects of international transfers when the donor country increases the fraction of its income or consumption tax revenue transferred as aid. The desirability of each method of aid financing is discussed from the viewpoint of national and world welfare, and conditions are identified under which aid improves world welfare with the one method of financing, and may worsen it with the other.     

Public-private partnerships in micro-finance: Should NGO involvement be restricted?

This paper examines public–private partnerships in micro-finance, whereby NGOs can help in channelizing credit to the poor, both in borrower selection, as well as in project implementation. We argue that a distortion may arise out of the fact that the private partner, i.e. the NGO, is a motivated agent. We find that whenever the project is neither too productive, nor too unproductive, reducing such distortion requires unbundling borrower selection and project implementation, with the NGO being involved in borrower selection only. Further, we compare and contrast two alternative credit delivery mechanisms, the linkage mechanism (which is the focus of this paper), with the ‘Grameen’ one.     

Group insurance and lending with endogenous social collateral

We construct a dynamic model of self-enforcing insurance provision and lending to a community of borrowers who are connected by risk-sharing arrangements that are themselves subject to enforcement problems, as in Kocherlakota (1996). We show that an outside lender offering constant-consumption contracts can earn a higher profit if he conditions his repeated interactions with each borrower on the history of his interactions with all the group members (a joint liability contract), rather than on his history with that borrower only (individual liability contracts). This result holds even in the absence of informational asymmetries. The observation driving it is that with individual liability contracts, a joint welfare-maximizing group may prefer to have one or more group members default on their contracts, so that the group can consume a mix of outside funds and the defaulters' stochastic income. One contribution of our work is to give precise economic content to the concept of “social collateral” as the per-agent surplus from group risk-sharing over autarky. The group can deter its members from defaulting on their contracts with the principal by threatening to reduce that surplus.