Borrower Lender

8/3/2019 Borrower Lender

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THE BORROWER-LENDER

RELATIONSHIP


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AGENDA

THE RISK SHARING APPROACH

COSTLY STATE VERIFICATION

INCENTIVES TO REPAY

INCOMPLETE CONTRACTS

DISCRIMINATING AMONG

BORROWERS


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THE STANDARD DEBT

CONTRACTdefinition:

repayment is independent of cash flows

If the cash flows are insufficient, all assetsgo to the lenders

If cash flows are insufficient, lenders get

control of the firm


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THE RISK SHARING

APPROACHAssume cash flows are risky butthere 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


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COSTLY STATE

VERIFICATIONObservation of the borrowers cash flows is

costly (auditing cost)

The contract can be designed so thatdepending on the repayment the borrower is

audited or not.

Minimisation of the auditing costs leads tothe Standard Debt Contract.


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CASH FLOWS

REPAYMENTS


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DRAWBACKS

Is the audit threat credible? Should not

renegotiation be introduced?

Random auditing with high penalties maybe more efficient


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Legal enforcement

yyyyyyPRy =+ )()(2

),( cp


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Legal enforcement

Recovery rates

No strategic default

Equilibrium:

),( cp

CyR cp +

),min()2(2 CRppR c+=


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Implications

Inefficient investment

Notice that a lower recovery rate on cash flows

will lead to collateral based lendingLow legal enforcement (high borrower

protection?) lead to lower levels of finance.


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INCENTIVES TO REPAY

Cash flows observation is infinitely costly

The incentives to repay may come from the

benefits of receiving funding in the future.


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INCENTIVES TO REPAY:

BOLTON-SHARFSTEIN

SOVEREIGN DEBT


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BOLTON-SHARFSTEIN(I)

Zero interest rates, risk neutral agents

A project may have a high or low non

verifiable cash flowIn a one period contract, the borrower will

pretend the low cash flow has obtained

As a consequence credit market would notexist


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BOLTON-SHARFSTEIN(II)

In the two period case the lender may

promise additional funding to the borrowers

that have repaid and no funding to thedefaulting ones

The incentives to repay for a successful firm

are now :

yyyyyyPRy =+ )()(2


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BOLTON-SHARFSTEIN(III)

In the dynamic case, a market for loans may

develop because the threat of termination

may provide the right incentivesThe bank promise to provide additional

funding has to be credible


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SOVEREIGN DEBT(I)

A simple model (Allen 1983)

The countrys profit are:

)2()(':

)2()(

rLfimplying

LrLf

+=

+=


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SOVEREIGN DEBT(II)

In an infinite horizon the present value of

being denied credit by the borrower is:

)()2(

))2()(()(2

LVLr

incentives

LrLfLVt

t

t

+

+==

=


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SOVEREIGN DEBT(III)

Credit rationing?

Bullow Rogoff argument


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INCOMPLETE CONTRACTS

EX ANTE DESIGN AND EX POST

RENEGOTIATION

CASH FLOWS VS. PLEDGEABLE CASH FLOWS


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DISCRIMINATING AMONG

BORROWERSASYMMETRIC INFORMATION AND

MECHANISM DESIGN

COLLATERAL AND REPAYMENTLOAN SIZE AND REPAYMENT

Borrower Lender

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