Moral Hazard, Reputation, and Fragility in Credit Markets

We analyze the extent to which reputational concerns may overcome moral hazard problems in credit markets. In such markets, loan contracts are common, and with loan contracts, borrowers have incentives to take on high levels of risk if lenders cannot observe the types of projects in which borrowers invest funds. If borrowers intend to access credit markets repeatedly, they have incentives to acquire reputations for taking on low levels of risk. We argue that in such repeated moral hazard environments, reputational incentives are fragile. We show that such environments are plagued by dynamic coordination problems, in the sense that sustaining reputational incentives requires lenders in different periods of time to coordinate their actions. We show that a natural way of solving these coordination problems leads to a fragile equilibrium in which small changes in fundamentals results in large fluctuations in lending activity. We argue that this fragility may play an important role in accounting for the observation that financial crises are a recurrent feature of market economies.