Verification Institutions in Financing Transactions

Abstract:     
This article examines the institutions that private parties have developed to resolve information asymmetries in financing transactions. It analyzes all of those institutions as variations on the hostage/bond transaction commonly described in the context of relational contracting.

The article proceeds in three steps. The first part provides a simple model of the bonding process that I use to describe the institutions discussed later in the article. That part emphasizes how a one-sided punitive hostage or bond arrangement provides a useful solution by enhancing the cost of a breach yet minimizing the incentive to opportunism by the holder of the bond. It also describes a variety of transactional difficulties that limit the circumstances in which the bond arrangement can be effective.

The second part uses that model to describe how and when that arrangement works for transactions that involve collateral, relational contracting, and reputational bonds. It concludes that many transactions that at first glance appear to involve that arrangement (such as secured commercial lending transactions) in fact do not rely on the incentives from that arrangement.

The third part extends the model to situations in which the borrower and the lender rely on a third party to verify information, either through use of a financial commitment (in the case of a guaranty or surety arrangement) or through some direct assertion of the information.

Note: This article formerly was University of Michigan Law School Working Paper No. 99-005.

JEL Classifications: G1, K2

Accepted Paper Series