Working Paper: NBER ID: w1697
Authors: Jonathan Eaton
Abstract: If contracts are costlessly enforcible then insolvency is the only reason for nonrepayment of loans. While some models have examined the borrower's incentive to repay, it has typically been assumed that the penalty suffered by a debtor in default is imposed automatically and without cost to the lender. If in fact invoking a penalty is costly, Pareto-improving loans may be dynamically inconsistent not because of the absence of a sufficiently harsh penalty for default, but because the lender has no incentive actually to implement the penalty in the event of default. In such situations infinitely-lived institutions can emerge as banking intermediaries between lenders and borrowers. These institutions, repeatedly involved in lending, have an incentive to enforce contracts that individual lenders lack. They can consequently sustain more lending. For their reputations as enforcers of contracts to have value requires that banks earn strictly positive profits. Maintaining the value of bank equity also provides an incentive for bankowners to invest deposits rather than to use these funds fraudulently. Because of the supernormal profits that banks must earn, an equilibrium that is sustained by bank reputation will not replicate an equilibrium in which loan repayment is automatically guaranteed.
Keywords: lending; repayment; financial institutions; costly enforcement; fraud
JEL Codes: G21; D82
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| existence of banks (G21) | willingness of lenders to provide loans (G21) |
| penalties for default (G33) | lender willingness to lend (G21) |
| existence of banks (G21) | credibility of enforcing penalties (K40) |
| penalties for default (G33) | equilibrium in lending markets (D53) |
| bank reputation (G21) | sustaining intertemporal trade (D15) |
| penalties imposed on borrowers (G21) | interest rates and welfare of lenders and borrowers (G21) |