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Moral Hazard and Capital Requirements in a Lending Model of Credit Denial

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  • Eric Van Tassel

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    Abstract

    In this paper we analyze a repeated game in which an intermediary offers unsecured loans to entrepreneurs using future credit denial to induce repayment. To finance the loans, the intermediary uses a combination of equity capital and external funds. We focus on a moral hazard problem that emerges between the intermediary and the less informed external investors over a costly loan monitoring choice. The presence of informed borrowers in the lender’s portfolio turns out to act as a substitute for capital requirements. The result is that the lending strategy utilized by the intermediary minimizes the moral hazard problem but implies the intermediary’s balance sheet is fragile to exogenous risk.

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    File URL: http://home.fau.edu/vantasse/web/BankMHRisk.pdf
    File Function: First version, 2009
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    Paper provided by Department of Economics, College of Business, Florida Atlantic University in its series Working Papers with number 09003.

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    Length: 32 pages
    Date of creation: May 2009
    Handle: RePEc:fal:wpaper:09003
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    Keywords: Moral hazard; Capital requirements; Bank regulation; Repayment incentives;

    Find related papers by JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation
    • O16 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Financial Markets; Saving and Capital Investment; Corporate Finance and Governance

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