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THE BORROWER-LENDER RELATIONSHIP PowerPoint PPT Presentation


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THE BORROWER-LENDER RELATIONSHIP. AGENDA. THE RISK SHARING APPROACH COSTLY STATE VERIFICATION INCENTIVES TO REPAY INCOMPLETE CONTRACTS DISCRIMINATING AMONG BORROWERS. THE COMPLEXITY OF CONTINGENT CONTRACTS. Repayments (Additional loans) Collateral The borrower’s actions (investment).

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THE BORROWER-LENDER RELATIONSHIP

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The borrower lender relationship l.jpg

THE BORROWER-LENDER RELATIONSHIP


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AGENDA

  • THE RISK SHARING APPROACH

  • COSTLY STATE VERIFICATION

  • INCENTIVES TO REPAY

  • INCOMPLETE CONTRACTS

  • DISCRIMINATING AMONG BORROWERS


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THE COMPLEXITY OF CONTINGENT CONTRACTS

  • Repayments (Additional loans)

  • Collateral

  • The borrower’s actions (investment)


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THE STANDARD DEBT CONTRACT

  • definition:

  • repayment is independent of cash flows

  • If the cash flows are insufficient, all assets go to the lenders

  • If cash flows are insufficient, lenders get control of the firm


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THE RISK SHARING APPROACH

  • Assume cash flows are risky but there is no asymmetric information

  • How is the optimal contract characterised?

  • For every cash flow, borrower and lender marginal utilities have to maintain a fixed ratio


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COSTLY STATE VERIFICATION

  • Observation of the borrower’s cash flows is costly (auditing cost)

  • The contract can be designed so that depending on the repayment the borrower is audited or not.

  • Minimisation of the auditing costs leads to the Standard Debt Contract.


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REPAYMENTS

CASH FLOWS


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DRAWBACKS

Is the audit threat credible? Should not renegotiation be introduced?

Random auditing with high penalties may be more efficient


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Legal enforcement


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Legal enforcement

  • Recovery rates

  • No strategic default

  • Equilibrium:


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Implications

  • Inefficient investment

    • Notice that a lower recovery rate on cash flows will lead to collateral based lending

  • Low legal enforcement (high borrower protection?) lead to lower levels of finance.


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INCENTIVES TO REPAY

  • Cash flows observation is infinitely costly

  • The incentives to repay may come from the benefits of receiving funding in the future.


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INCENTIVES TO REPAY:

  • BOLTON-SHARFSTEIN

  • SOVEREIGN DEBT


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BOLTON-SHARFSTEIN(I)

  • Zero interest rates, risk neutral agents

  • A project may have a high or low non verifiable cash flow

  • In a one period contract, the borrower will pretend the low cash flow has obtained

  • As a consequence credit market would not exist


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BOLTON-SHARFSTEIN(II)

  • In the two period case the lender may promise additional funding to the borrowers that have repaid and no funding to the defaulting ones

  • The incentives to repay for a successful firm are now :


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BOLTON-SHARFSTEIN(III)

  • In the dynamic case, a market for loans may develop because the threat of termination may provide the right incentives

  • The bank promise to provide additional funding has to be credible


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A simple model (Allen 1983)

The country’s profit are:

SOVEREIGN DEBT(I)


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SOVEREIGN DEBT(II)

  • In an infinite horizon the present value of being denied credit by the borrower is:


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SOVEREIGN DEBT(III)

  • Credit rationing?

  • Bullow Rogoff argument


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INCOMPLETE CONTRACTS

  • EX ANTE DESIGN AND EX POST RENEGOTIATION

  • CASH FLOWS VS. PLEDGEABLE CAS H FLOWS


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DISCRIMINATING AMONG BORROWERS

  • ASYMMETRIC INFORMATION AND MECHANISM DESIGN

  • COLLATERAL AND REPAYMENT

  • LOAN SIZE AND REPAYMENT


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