Debt Contracts, Collapse and Regulation as Competition Phenomena

CEPR Discussion Paper No. 1742

Posted: 8 Aug 1998

See all articles by Hans Gersbach

Hans Gersbach

ETH Zurich - CER-ETH -Center of Economic Reseaarch; IZA Institute of Labor Economics; CESifo (Center for Economic Studies and Ifo Institute); Centre for Economic Policy Research (CEPR)

Harald Uhlig

University of Chicago - Department of Economics

Date Written: November 1997

Abstract

This paper studies a credit market with adverse selection and moral hazard where sufficient sorting is impossible. The crucial novel feature is the competition between lenders in their choice of contracts offered. The quality of investment projects is unobservable by banks and entrepreneurs? investment decisions are not contractible, but output conditional on investment is. The paper explains the empirically observed prevalence of debt contracts as an equilibrium phenomenon with competing lenders. Equilibrium contracts must be immune against raisin-picking by competitors. Non-debt contracts allow competitors to offer sweet deals to particularly good debtors, who will self-select to choose such a deal, while bad debtors distribute themselves across all offered contracts. Competition between banks introduces three possibilities for a breakdown of credit markets which do not occur when a bank has a monopoly. First, average returns decrease since banks compete for good lenders, which may make lending altogether unprofitable. Second, banks can have an incentive to offer a debt contract and additional equity contracts to intermediate debtors, which is in turn dominated by a simple debt contract, only attractive for very good entrepreneurs. As a result, no equilibrium in pure strategies exists. Existence can be restored in this scenario if the permissible types of contracts are limited by regulation resembling the separation of investment and commercial banking in the United States. Finally, allowing for random delivery on credit contracts leads to a breakdown since all banks seek to avoid the contract with the highest chance of delivery: that contract attracts all bad entrepreneurs.

JEL Classification: D43, D80, D92, G24, G28, G32, G38

Suggested Citation

Gersbach, Hans and Uhlig, Harald, Debt Contracts, Collapse and Regulation as Competition Phenomena (November 1997). CEPR Discussion Paper No. 1742, Available at SSRN: https://ssrn.com/abstract=111648

Hans Gersbach (Contact Author)

ETH Zurich - CER-ETH -Center of Economic Reseaarch ( email )

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IZA Institute of Labor Economics

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CESifo (Center for Economic Studies and Ifo Institute)

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Centre for Economic Policy Research (CEPR)

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Harald Uhlig

University of Chicago - Department of Economics ( email )

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Chicago, IL 60637
United States

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