Lending with costly enforcement of repayment and potential fraud
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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- Thomas J. Sargent & Neil Wallace, 1981. "The real bills doctrine vs. the quantity theory: a reconsideration," Staff Report 64, Federal Reserve Bank of Minneapolis.
- Klein, Benjamin & Leffler, Keith B, 1981. "The Role of Market Forces in Assuring Contractual Performance," Journal of Political Economy, University of Chicago Press, vol. 89(4), pages 615-41, August.
- Kletzer, Kenneth M, 1984. "Asymmetries of Information and LDC Borrowing with Sovereign Risk," Economic Journal, Royal Economic Society, vol. 94(374), pages 287-307, June.
- Sargent, Thomas J & Wallace, Neil, 1982. "The Real-Bills Doctrine versus the Quantity Theory: A Reconsideration," Journal of Political Economy, University of Chicago Press, vol. 90(6), pages 1212-36, December.
- 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, vol. 66, pages 467.
- James W. Friedman, 1971. "A Non-cooperative Equilibrium for Supergames," Review of Economic Studies, Oxford University Press, vol. 38(1), pages 1-12.
- Jonathan Eaton & Mark Gersovitz, 1981. "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, Oxford University Press, vol. 48(2), pages 289-309.
- Dwight M. Jaffee & Thomas Russell, 1976. "Imperfect Information, Uncertainty, and Credit Rationing," The Quarterly Journal of Economics, Oxford University Press, vol. 90(4), pages 651-666.
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