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Financial Contracting with Enforcement Externalities

Author

Listed:
  • Lukasz A. Drozd
  • Ricardo Serrano-Padial

Abstract

We study the negative feedback loop between the aggregate default rate and the efficacy of enforcement in a model of debt-financed entrepreneurial activity. The novel feature of our model is that enforcement capacity is accumulated ex ante and thus subject to depletion ex post. We characterize the effect of shocks that deplete enforcement resources on the aggregate default rate and credit supply. In the model default decisions by entrepreneurs are strategic complements, leading to multiple equilibria. We propose a global game selection to overcome equilibrium indeterminacy and show how shocks that deplete enforcement capacity can lead to a spike in the aggregate default rate and trigger credit rationing.

Suggested Citation

  • Lukasz A. Drozd & Ricardo Serrano-Padial, 2018. "Financial Contracting with Enforcement Externalities," Working Papers 18-21, Federal Reserve Bank of Philadelphia.
    • Handle: RePEc:fip:fedpwp:18-21
    DOI: https://doi.org/10.21799/frbp.wp.2018.21
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    Cited by:

    1. Liang Dai & Dan Luo & Ming Yang, 2024. "Disclosure of Bank-Specific Information and the Stability of Financial Systems," The Review of Financial Studies, Society for Financial Studies, vol. 37(4), pages 1315-1367.
    2. Alexandre, Michel & Silva, Thiago Christiano & Michalak, Krzysztof & Rodrigues, Francisco Aparecido, 2023. "Does the default pecking order impact systemic risk? Evidence from Brazilian data," European Journal of Operational Research, Elsevier, vol. 309(3), pages 1379-1391.
    3. Fabio Schiantarelli & Massimiliano Stacchini & Philip E. Strahan, 2020. "Bank Quality, Judicial Efficiency, and Loan Repayment Delays in Italy," Journal of Finance, American Finance Association, vol. 75(4), pages 2139-2178, August.
    4. Toshihiko Mukoyama & Latchezar Popov, 2020. "Industrialization and the evolution of enforcement institutions," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 69(3), pages 745-788, April.
    5. Krause, Andreas, 2022. "Strategic default and optimal audit resources with costly state verification," Research in Economics, Elsevier, vol. 76(4), pages 413-421.

    More about this item

    Keywords

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    JEL classification:

    • C72 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Noncooperative Games
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • O16 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Financial Markets; Saving and Capital Investment; Corporate Finance and Governance

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