The global financial market is currently undergoing one of the worst and perhaps most damaging financial crisis since the Great Depression. This crisis is affecting countries from all over the globe and it appears that no country is immune from the current financial malaise. Unfortunately, the global financial are not new. Indeed, over the past three decades, the global financial market has witnessed several financial crises involving mainly developing countries from Latin America to East Asia. These past events; however, were not as widespread and severe as the one presently being faced.
During the last years, there has been a revived interest in the theory of dynamic contracting. However, although most of the research incorporates some form of limited commitment/enforcement, little has been done in terms of extending the notion of commitment per se. In particular, there is no reason to believe that the outside option is constant across the history of observables. For example, it is unrealistic to treat the reservation utility of a CEO as fixed regardless of the situation in his/her firm, industry, or the economy as a whole. The dependence could come through many channels externalities, different types of agents, a certain structure of beliefs, but more importantly, it can significantly influence the nature of the relationship and the form of the optimal contract. Moreover, extending the notion of commitment can bring some important insights into various contractual problems. For example, in order to address the wide use of broad based stock option plans, Oyer (2004) builds a simple 2 period model where adjusting compensation is costly and employeels outside opportunities are correlated with the firms performance.
In this sense, what remains to be done is to generalize the notion of commitment by defining the outside options on the history observed in a dynamic contractual setting. The current paper considers a moral hazard problem in an infinitely repeated principal agent interaction while allowing the reservation utilities of both par ties to vary across the history of observables. More precisely, to keep the model tractable, the reservation utilities are assumed to depend on some finite truncation of the publicly observed history. The rest of the model is standard in the sense that the principal wants to implement some sequence of actions which stochastically affect a variable of his/her interest, but suffers from the fact that the actions are unobservable. For this purpose, the optimal contract needs to provide the proper incentives for the agent to exercise the sequence of actions suggested by the principal. The incentives, however, are restricted by the in ability of the parties to commit to a long term relationship. It is here where the dynamics of the reservation utilities enters the relationship by reshaping the set of possible self#enforcing, incentive compatible contracts.
Access to finance and, by extension, a well functioning financial sector are of central importance for economic growth and development. Starting with King and Levine (1993) and, more recently, Rajan and Zingales (1998) a growing body of literature has shown that a country’s level of financial development has a direct bearing on its economic prospects (see, e.g., Beck et al., 2000). In particular, inefficient domestic banking systems often constrain growth because firms with external financing needs lack access to credit, especially in developing countries. In this context, the role of foreign banks in mitigating financial inefficiencies is ambiguous.
On the one hand, foreign lenders can act as catalysts for financial development through superior expertise (Claessens et al., 2001), provide new sources of financing (BIS, 2001 and 2006), and might induce consolidation in fragmented banking systems (Gelos and Roldos, 2004), which all can improve the efficiency of local intermediation and availability of credit (Beck et al., 2004). On the other hand, foreign entry might exert competitive pressures on domestic banks which, in response, cut back their own lending activities (Giannetti and Ongena, 2007) to such a degree that the overall availability of credit decreases (Gormley, 2008). Hence, the effect of foreign banks on domestic economic activity is both an important empirical and policy question all the more that existing work offers conflicting predictions and contradictory empirical evidence.
