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Financing Repeat Borrowers: Designing Credible Incentives for Today and Tomorrow

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Abstract

We analyze relational contracts between a lender and borrower when borrower cash flows are not contractible and the costs of intermediation vary over time. Because lenders provide repayment incentives to borrowers through the continuation value of the lending relationship, borrowers will condition loan repayment on the likelihood of receiving loans in the future. Therefore, the borrower's beliefs about the lender's future liquidity and profitability become an important component of the borrower's repayment decision. Consequently, the possibility of high lending costs in the future weakens repayment incentives and can cause the borrower to strategically default in some states and an inefficient under-provision of credit. We characterize the optimal relational contract and discuss the application of our model to the case of microfinance and trade credit.

Suggested Citation

  • Anil K. Jain, 2022. "Financing Repeat Borrowers: Designing Credible Incentives for Today and Tomorrow," International Finance Discussion Papers 1364, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgif:1364
    DOI: 10.17016/IFDP.2022.1364
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    Keywords

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    JEL classification:

    • O16 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Financial Markets; Saving and Capital Investment; Corporate Finance and Governance
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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