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Lending with Costly Enforcement of Repayment and Potential Fraud

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  • 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.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 1697.

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Date of creation: Sep 1985
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Publication status: published as Eaton, Jonathan. "Lending with Costly Enforcement of Repayment and Potential Fraud," Journal of Banking and Finance, International Colloquium in Memory of Daniel Recanti, A Special Issue, Vol. 10, No. 2, pp. 281-294, June 1986.
Handle: RePEc:nbr:nberwo:1697

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  1. Klein, Benjamin & Leffler, Keith B, 1981. "The Role of Market Forces in Assuring Contractual Performance," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 89(4), pages 615-41, August.
  2. Sargent, Thomas J & Wallace, Neil, 1982. "The Real-Bills Doctrine versus the Quantity Theory: A Reconsideration," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 90(6), pages 1212-36, December.
  3. Thomas J. Sargent & Neil Wallace, 1981. "The real bills doctrine vs. the quantity theory: a reconsideration," Staff Report, Federal Reserve Bank of Minneapolis 64, Federal Reserve Bank of Minneapolis.
  4. Eaton, Jonathan & Gersovitz, Mark, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 48(2), pages 289-309, April.
  5. Kletzer, Kenneth M, 1984. "Asymmetries of Information and LDC Borrowing with Sovereign Risk," Economic Journal, Royal Economic Society, Royal Economic Society, vol. 94(374), pages 287-307, June.
  6. Jaffee, Dwight M & Russell, Thomas, 1976. "Imperfect Information, Uncertainty, and Credit Rationing," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 90(4), pages 651-66, November.
  7. Paul A. Samuelson, 1958. "An Exact Consumption-Loan Model of Interest with or without the Social Contrivance of Money," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 66, pages 467.
  8. Friedman, James W, 1971. "A Non-cooperative Equilibrium for Supergames," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 38(113), pages 1-12, January.
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Cited by:
  1. Bruce C. Greenwald & Joseph E. Stiglitz, 1991. "Information, Finance, and Markets: The Architecture of Allocative Mechanisms," NBER Working Papers 3652, National Bureau of Economic Research, Inc.
  2. Joshua Aizenman, 1987. "Country Risk and Contingencies," NBER Working Papers 2236, National Bureau of Economic Research, Inc.
  3. Laurence J. Kotlikoff & Torsten Persson & Lars E.O. Svensson, 1986. "Laws as Assets: A Possible Solution to the Time Consistency Problem," NBER Working Papers 2068, National Bureau of Economic Research, Inc.
  4. Joshua Aizenman, 1986. "Country Risk, Asymmetric Information and Domestic Policies," NBER Working Papers 1880, National Bureau of Economic Research, Inc.
  5. Joshua Aizenman, 1986. "Country Risk and Incentives Schemes," NBER Working Papers 2031, National Bureau of Economic Research, Inc.

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