Legal enforcement, default and heterogeneity of project-financing contracts

This paper employs mechanism design to examine how imperfect legal enforcement impacts simultaneously the availability of credit for investment and interest rates. The analysis combines limited commitment, which encapsulates the idea that courts are imperfect, and asymmetric information about cash flows, which makes debt contracts optimal. Costly use of courts may be optimal, which differs from most limited commitment models, where punishments are merely threats, never actually applied in optimal arrangements. Paradoxically, liquidation by courts only happens in optimal arrangements when courts are imperfect. Credit constraints emerge, but even credit-constrained individuals do not borrow as much as they can. Consistent with stylized facts, wealthier individuals borrow at lower interest rates and run larger-scale enterprises. The reliability of courts has a positive effect on the scale of projects. However, its effect on interest rates is more subtle and depends on the degree of curvature of the production function. Copyright Springer-Verlag Berlin Heidelberg 2014