Ebook Renegotiation In Debt Contracts
This paper studies dynamic financial contracting when cash flows are not contractible. In such contracts, the prevention of default relies on the threat that the borrower be denied access to credit in the future. We identify the ability of parties to renegotiate the initial contract as an important constraint on the form and profitability of optimal contracts.
In credit transactions, the terms of the exchange are not simultaneous. For instance, the repayment of a loan falls due some time after the loan is granted. Because of their dynamic nature, credit arrangements have to take into account the possibility that one party, the borrower, does not deliver his term of the exchange in the future. At the time the borrower should repay the loan, he may be unable to do so, typically because the project financed by the loan failed, was delayed or did not generate enough returns. This is a case of liquidity default. However, the debtor may be able to repay the loan but choose not to do so. This is a case of strategic default.
Preventing strategic defaults is crucial to the profitability of credit transactions for lenders, and thus, in some cases, to the very existence of credit markets. The question is, how to make sure that the debtor repays whenever he can? One idea is to impose direct costs of default. A priori, criminal penalties could be used. Alternatively, the lender could be entitled to seize a collateral, for instance some physical assets financed through the loan. However, direct penalties may not be completely effective when it is costly to distinguish liquidity from strategic defaults. Severely punishing defaults irrespective of their being voluntary or not would lead to unjust punishments being enforced. This could in turn deter potential borrowers from taking loans, and so the credit market might collapse. Hence, the mere existence of a credit market is likely to necessitate moderate penalties and that the borrowers’ liability be limited.
Several authors have emphasized that the repetition of lending can help discipline a borrower without collateral or when, as in the case of a sovereign country, courts have little power to enforce contracts. The general idea is that the borrower’s current behavior can impact on the terms of his access to credit in the future. Hence, there may be indirect costs of default. For instance, a borrower with a bad track record is likely to face high interest rates in the future due to his bad reputation. Even absent reputation effects of default, the lenders can simply decide to deny further access to credit after too many defaults. Then, the current repayment is (less or) equal to the borrower’s valuation of future access to credit. The more valuable future credit is, the higher the current repayment can be. In a way, the borrower is a prisoner of the profitability of his future projects.
This paper turns this idea on its head and shows how the lender can be the prisoner. We highlight the credibility problem that limits the effectiveness of such a threat. If the future relationship between the lender and the borrower is profitable, the lender has little incentive to put it to an end ex-post, i.e. after a default. Hence, ex-ante the threat of denying the borrower new capital is weakened.
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