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Reputation and Credit Market Formation: How Relational Incentives and Legal Contract Enforcement Interact

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  • Fehr, Ernst

    ()
    (University of Zurich)

  • Zehnder, Christian

    ()
    (University of Lausanne)

Abstract

The evidence suggests that relational contracting and legal rules play an important role in credit markets but on the basis of the prevailing field data it is difficult to pin down their causal impact. Here we show experimentally that relational incentives are a powerful causal determinant for the existence and performance of credit markets. In fact, in the absence of legal enforcement and reputation formation opportunities the credit market breaks down almost completely while if reputation formation is possible a stable credit market emerges even in the absence of legal enforcement of debt repayment. Introducing legal enforcement of repayments causes a further significant increase in credit market trading but has only a surprisingly small impact on overall efficiency. The reason is that legal enforcement of debt repayments weakens relational incentives and exacerbates another moral hazard problem in credit markets – the choice of inefficient high-risk projects.

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Bibliographic Info

Paper provided by Institute for the Study of Labor (IZA) in its series IZA Discussion Papers with number 4351.

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Length: 51 pages
Date of creation: Aug 2009
Date of revision:
Handle: RePEc:iza:izadps:dp4351

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Keywords: credit markets; relationship lending; reputation formation; legal enforcement;

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Cited by:
  1. Stefan Trautmann & Razvan Vlahu, 2011. "Strategic Loan Defaults and Coordination: An Experimental Analysis," DNB Working Papers 312, Netherlands Central Bank, Research Department.
  2. Brown, Martin & Serra-Garcia, Marta, 2011. "The Threat of Exclusion and Relational Contracting," Discussion Papers in Economics 12287, University of Munich, Department of Economics.
  3. Brown, Martin & Serra-García, Marta, . "The Threat of Exclusion and Relational Contracting," Working Papers on Finance 1407, University of St. Gallen, School of Finance.
  4. Brown, M. & Serra Garcia, M., 2010. "Relational Contracting Under the Threat of Expropriation – Experimental Evidence," Discussion Paper 2010-85, Tilburg University, Center for Economic Research.
  5. Martin Brown & Stefan Trautmann & Razvan Vlahu, 2012. "Contagious Bank Runs: Experimental Evidence," DNB Working Papers 363, Netherlands Central Bank, Research Department.

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