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Legal Enforcement, Default and Heterogeneity of Project Financing Contracts

  • Gabriel de Abreu Madeira

    ()

This paper employs mechanism design to study how imperfect legal enforcement impacts simultaneously on the availability (or scale) of credit for investment and interest rates. The analysis combines two standard ingredients of the development and contract literatures: limited commitment, which encapsulates the idea that contract enforcement is imperfect, and asymmetric information about cash flows, which justifies debt contracts and default under some circumstances. Costly use of courts may be optimal, which differs from most limited commitment models, where punishments are just threats, never applied in optimal arrangements. Paradoxically, liquidation by courts only happens in equilibrium when courts are imperfect. Numerical solutions for several parametric specifications, allowing for heterogeneity on initial wealth are provided. In all such solutions, wealthier individuals borrow with lower interest rates and run higher scale enterprises, which is consistent with stylized facts. The reliability of courts has a consistently positive effect on the scale of projects. However its effect on interest rates is subtler and depends on the degree of curvature of the production function.

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File URL: http://www.fea.usp.br/feaecon/RePEc/documentos/GabrielMadeira_31WP.pdf
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Paper provided by University of São Paulo (FEA-USP) in its series Working Papers, Department of Economics with number 2012_31.

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Date of creation: 07 Dec 2012
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Handle: RePEc:spa:wpaper:2012wpecon31
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  1. Stephen D. Williamson, 1984. "Costly Monitoring, Loan Contracts and Equilibrium Credit Rationing," Working Papers 572, Queen's University, Department of Economics.
  2. Rafael LaPorta & Florencio Lopez-de-Silanes & Andrei Shleifer & Robert W. Vishny, . "Law and Finance," Working Paper 19451, Harvard University OpenScholar.
  3. Dan Bernhardt & Huw Lloyd-Ellis, 1993. "Enterprise, Inequality and Economic Development," Working Papers 893, Queen's University, Department of Economics.
  4. Greenwood, Jeremy & Jovanovic, Boyan, 1990. "Financial Development, Growth, and the Distribution of Income," Journal of Political Economy, University of Chicago Press, vol. 98(5), pages 1076-1107, October.
  5. Rui Albuquerque & Hugo Hopenhayn, 2002. "Optimal Lending Contracts and Firm Dynamics," RCER Working Papers 493, University of Rochester - Center for Economic Research (RCER).
  6. Oliver Hart & John Moore, 1997. "Default and Renegotiation: A Dynamic Model of Debt," Harvard Institute of Economic Research Working Papers 1792, Harvard - Institute of Economic Research.
  7. Magnac, Thierry & Robin, Jean-Marc, 1996. "Occupational choice and liquidity constraints," Ricerche Economiche, Elsevier, vol. 50(2), pages 105-133, June.
  8. Ana Carla A. Costa & Joao M.P. De Mello, 2006. "Judicial Risk and Credit Market Performance: Micro Evidence from Brazilian Payroll Loans," NBER Working Papers 12252, National Bureau of Economic Research, Inc.
  9. Evans, David S & Jovanovic, Boyan, 1989. "An Estimated Model of Entrepreneurial Choice under Liquidity Constraints," Journal of Political Economy, University of Chicago Press, vol. 97(4), pages 808-27, August.
  10. Stefan Krasa & Anne P. Villamil, 2000. "Optimal Contracts when Enforcement Is a Decision Variable," Econometrica, Econometric Society, vol. 68(1), pages 119-134, January.
  11. Gale, Douglas & Hellwig, Martin, 1985. "Incentive-Compatible Debt Contracts: The One-Period Problem," Review of Economic Studies, Wiley Blackwell, vol. 52(4), pages 647-63, October.
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