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Debt Contracts, Collapse and Regulation as Competition Phenomena

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  • Gersbach, H.
  • Uhlig, H.F.H.V.S.

    (Tilburg University, Center for Economic Research)

Abstract

We study a credit market with adverse selection and moral hazard where sufficient sorting is impossible. The crucial novel feature is the competition between lenders in their choice of contracts offered. Qualities of investment projects are not observable by banks and investment decisions of entrepreneurs are not contractible, but output conditional on investment is. We explain the empirically observed prevalence of debt contracts as an equilibrium phenomenon with competing lenders. Equilibrium contracts must be immune against raisin-picking by competitors. Non-debt contracts allow competitors to offer sweet deals to particularly good debtors, who will self-select to choose such a deal, while bad debtors distribute themselves across all offered contracts. Competition of banks introduces three possibilities for a breakdown of credit markets that do not occur when a bank has a monopoly. First, average returns decrease since banks compete for good lenders which may make the lending altogether unprofitable. Second, banks can have an incentive to offer a debt contract and additional equity contracts to intermediate debtors. This combination, however, is in turn dominated by a simple debt contract that is only attractive for very good entrepreneurs. As a result no equilibrium in pure strategies exists. Existence can be restored, if the permissible types of contracts are limited by regulation resembling the separation of investment and commercial banking in the U.S. Third, allowing for random delivery on credit contracts leads to a break-down since all banks want to avoid the contract with the highest chance of delivery: that contract attracts all bad entrepreneurs.

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Bibliographic Info

Paper provided by Tilburg University, Center for Economic Research in its series Discussion Paper with number 1998-01.

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Date of creation: 1998
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Handle: RePEc:dgr:kubcen:199801

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Web page: http://center.uvt.nl

Related research

Keywords: contract; debt contract; adverse selection; moral hazard; competition; financial collapse; regulation;

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Cited by:
  1. Hans Gersbach & Jan Wenzelburger, 2001. "The Dynamics of Deposit Insurance and the Consumption Trap," CESifo Working Paper Series 509, CESifo Group Munich.
  2. Lee Ohanian, 2000. "EconomicDynamics Interviews Lee Ohanian on the Great Depression," EconomicDynamics Newsletter, Review of Economic Dynamics, vol. 1(2), April.
  3. Harald Uhlig, 2001. "EconomicDynamics Interviews Harald Uhlig on Dynamic Contracts," EconomicDynamics Newsletter, Review of Economic Dynamics, vol. 2(2), April.
  4. Hans Gersbach, 2002. "Financial Intermediation and the Creation of Macroeconomic Risks," CESifo Working Paper Series 695, CESifo Group Munich.

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