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Lending with Costly Enforcement of Repayment and Potential Fraud

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  • Jonathan Eaton

Abstract

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.

Suggested Citation

  • Jonathan Eaton, 1985. "Lending with Costly Enforcement of Repayment and Potential Fraud," NBER Working Papers 1697, National Bureau of Economic Research, Inc.
  • Handle: RePEc:nbr:nberwo:1697 Note: ITI IFM
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    1. James W. Friedman, 1971. "A Non-cooperative Equilibrium for Supergames," Review of Economic Studies, Oxford University Press, vol. 38(1), pages 1-12.
    2. 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 467-467.
    3. 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.
    4. Thomas J. Sargent & Neil Wallace, 1981. "The real bills doctrine vs. the quantity theory: a reconsideration," Staff Report 64, Federal Reserve Bank of Minneapolis.
    5. 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 615-641, August.
    6. 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.
    7. 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.
    8. 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 1212-1236, December.
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    Cited by:

    1. Laurence J. Kotlikoff & Torsten Persson & Lars E.O. Svensson, 1986. "Laws as Assets: A Possible Solution to the Time Consistency Problem," NBER Working Papers 2068, National Bureau of Economic Research, Inc.
    2. Jonathan Eaton & Mark Gersovitz & Joseph E. Stiglitz, 1991. "The Pure Theory of Country Risk," NBER Chapters,in: International Volatility and Economic Growth: The First Ten Years of The International Seminar on Macroeconomics, pages 391-435 National Bureau of Economic Research, Inc.
    3. Joseph E. Stiglitz, 2015. "Towards a General Theory of Deep Downturns," NBER Working Papers 21444, National Bureau of Economic Research, Inc.
    4. Joshua Aizenman, 1987. "Country Risk and Contingencies," NBER Working Papers 2236, National Bureau of Economic Research, Inc.
    5. Joshua Aizenman, 1986. "Country Risk and Incentives Schemes," NBER Working Papers 2031, National Bureau of Economic Research, Inc.
    6. Bruce C. Greenwald & Joseph E. Stiglitz, 1991. "Information, Finance, and Markets: The Architecture of Allocative Mechanisms," NBER Working Papers 3652, National Bureau of Economic Research, Inc.
    7. Joshua Aizenman, 1986. "Country Risk, Asymmetric Information and Domestic Policies," NBER Working Papers 1880, National Bureau of Economic Research, Inc.

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