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Competition, risk neutrality and loan commitments

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  • Boot, A.W.A.
  • Thakor, A.V.
  • Udell, G.F.

    (Tilburg University, Faculty of Economics and Business Administration)

Abstract

We rationalize fixed rate loan commitments (forward credit contracting with options) in a competitive credit market with universal risk neutraility. Future interest rates are random, but there are no transactions costs. Borrowers finance projects with bank loans and choose ex post unobseravable actions that affect project payoffs. Credit contract design by the bank is the outcome of a (non-cooperative) Nash game between the bank and the borrower. The initial formal analysis is basically in two steps. First, we show that the only spot credit market Nash equilibria that exist are inefficient in the sense that they result in welfare losses for borrowers due to the bank's informational handicap. Second, we show that loan commitments, because of their ability to weaken the link between the offering bank's expected profit and the loan interest rate, enable to the complete elimination of informationally induced welfare losses and thus produce an outcome that strictly Pareto dominates any spot market equilibrium. Perhaps our most surprising result is that, if the borrower has some initial liquidity, it is better for the borrower to use it now to pay a commitment fee and buy a loan commitment that entitles it to borrow in the future rather than save it for use as an inside equity in conjunction with spot borrowing.

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Bibliographic Info

Paper provided by Tilburg University, Faculty of Economics and Business Administration in its series Research Memorandum with number 260.

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Date of creation: 1987
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Handle: RePEc:dgr:kubrem:1987260

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Web page: http://www.tilburguniversity.edu/nl/over-tilburg-university/schools/economics-and-management/

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References

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  1. Marcia H. Millon & Anjan V. Thakor, 2004. "Moral Hazard and Information Sharing: A Model of Financial Information Gathering Agencies," Finance 0411024, EconWPA.
  2. Yuk-Shee Chan & Anjan V. Thakor, 2004. "Collateral and Competitive Equilibria with Moral Hazard and Private Information," Finance 0411019, EconWPA.
  3. Campbell, Tim S, 1978. "A Model of the Market for Lines of Credit," Journal of Finance, American Finance Association, vol. 33(1), pages 231-44, March.
  4. Anjan V. Thakor & Gregory F. Udell, 2004. "An Economic Rationale for the Pricing Structure of Bank Loan Commitments," Finance 0411053, EconWPA.
  5. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, vol. 51(3), pages 393-414, July.
  6. Jaffee, Dwight M & Russell, Thomas, 1976. "Imperfect Information, Uncertainty, and Credit Rationing," The Quarterly Journal of Economics, MIT Press, vol. 90(4), pages 651-66, November.
  7. Wilson, Charles, 1977. "A model of insurance markets with incomplete information," Journal of Economic Theory, Elsevier, vol. 16(2), pages 167-207, December.
  8. James, Christopher, 1981. "Self-Selection and the Pricing of Bank Services: an Analysis of the Market for Loan Commitments and the Role of Compensating Balance Requirements," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 16(05), pages 725-746, December.
  9. Robert Townsend, 1979. "Optimal contracts and competitive markets with costly state verification," Staff Report 45, Federal Reserve Bank of Minneapolis.
  10. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
  11. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June.
  12. Harris, Milton & Raviv, Artur, 1979. "Optimal incentive contracts with imperfect information," Journal of Economic Theory, Elsevier, vol. 20(2), pages 231-259, April.
  13. Melnik, Arie & Plaut, Steven E., 1986. "The economics of loan commitment contracts: Credit pricing and utilization," Journal of Banking & Finance, Elsevier, vol. 10(2), pages 267-280, June.
  14. Gale, Douglas & Hellwig, Martin, 1985. "Incentive-Compatible Debt Contracts: The One-Period Problem," Review of Economic Studies, Wiley Blackwell, vol. 52(4), pages 647-63, October.
  15. Ramakrishnan, Ram T S & Thakor, Anjan V, 1984. "Information Reliability and a Theory of Financial Intermediation," Review of Economic Studies, Wiley Blackwell, vol. 51(3), pages 415-32, July.
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