Repeated lending under contractual incompleteness |
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Authors: | Vinicius Carrasco João Manoel Pinho De Mello |
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Institution: | (1) Department of Economics, University of Rostock, Ulmenstr. 69, 18057 Rostock, Germany;(2) IFZ Institute for Financial Services Zug, University of Applied Sciences Central Switzerland, Grafenauweg 10, Postfach 4332, CH-6304 Zug, Switzerland |
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Abstract: | We consider a model of repeated (relationship) lending in which some contingencies that are relevant for a bank’s decision
to finance a project cannot be described contractually. The hazards related to this lack of contractibility can be magnified
by actions taken by an entrepreneur. The continuation value of a lending relationship induces borrowers to take actions that
minimize the ex-post conflict of interests resulting from contractual incompleteness. The optimal lending relationship is stationary on the equilibrium
path. A robust feature of an optimal lending relationship is that the action schedule (as a function of project types) adopted
by the entrepreneur is either a constant or a step function. Hence, the bank imposes to the entrepreneur a finite set of decisions
from which he can pick his action, bounding his discretion over decisions. This leads to lower interest rates charged by the
bank and to efficient refinancing in a lending relationship when compared to arm’s length financing. |
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