Two-period financial contracts and product market competition

This paper examines optimal two-period financial contracts between firms in a product market on the one side and banks as creditors on the other side. Similar to the Bolton-Scharfstein contracts, banks can mitigate the moral hazard problem of truthfully revealing the ex ante unknown profits of firms by credibly committing to terminate funding in the second period if the firms' Performance in the first period is poor. In contrast to Bolton-Scharfstein contracts we assume that the firms rather than the banks have all the bargaining power. We show that the termination threat will still be used by banks, but to a lesser extent, thereby making the contracts more efficient. Efficiency decreases, however, with the banks' market power because the probability of continued funding in the second period declines. Using the consumer switching cost approach to model Strategie price competition between the rivals in a product market, we can fiirthermore show that the need for debt financing leads to a price increase in the product market. On the one hand this effect is due to the information problem itself, on the other hand it is strengthened by the market power of banks.