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.
Since Bernanke and Blinderps (1992) observation that significant movements in aggregate bank lending volume follow changes in the stance of monetary policy, the bank lending channel (henceforth, BLC) has been a prominent mechanism in the literature on monetary transmission. The BLC focuses on the balance sheets of commercial banks and assumes that insured, reservable deposits and other forms of external loan finance (e.g. time deposits, CDs, etc.) are not perfect substitutes due to the higher costs of acquiring the latter. Therefore, a monetary contraction resulting in less reservable deposits should result in a decrease in the supply of loans.
Building upon the initial intuition for the BLC, the literature has since stressed cross sectional differences among commercial banks balance sheets as well as loan components. Kashyap and Stein (1995, 2000) considered bank assets and liquidity positions as aggregating criteria and find that increases in the Federal funds rate are followed by significant declines in lending volume for the smallest (in terms of assets) and least liquid banks. Den Haan et al. (2007) consider loan components aggregated across banks and find that real estate and consumer loans decline sharply in response to a monetary contraction while commercial and industrial (C&I) loans increase. While Perez (1998), Ashcraft (2006), and others have questioned the macroeconomic significance of the BLC in monetary transmission, Kashyap and Stein (1995, 2000) and Den Haan et al. (2007) remain as evidence for its existence.
The main purpose of this paper is to build an equilibrium model of the capital market, comprising a banking sector as well as a primary securities market, which is consistent with the main stylized facts that are known about stock and credit markets.
