Legal Enforcement, Default and Heterogeneity of Project Financing Contracts

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.