This paper relates credit market structure to efficiency in product markets. It is shown that debt financing with limited liability mute the borrower's incentives. The main theorem compares "industry banking" to independent financing of firms. When firms' effort levels are strategic substitutes and costs are convex, independent financing Pareto-dominates industry financing. The contract offered by an industry bank both compensates for the externality between firms and incorporates an element of rent-extraction. The cumulative effect yields a suboptimal level of effort. When firms are sufficiently strong at bargaining, banks will be held down to their break-even payoff, and the outcome on the product market only depends on the riskless rate of interest.
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Paper provided by University of Copenhagen. Department of Economics in its series Discussion Papers with number
99-14.
Length: 30 pages Date of creation: Apr 1999 Date of revision: Handle: RePEc:kud:kuiedp:9914
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