'Long Term Debt with Hidden Borrowing'

Abstract

We consider borrowers with the opportunity to raise funds from a competitive banking sector that shares information, and from an alternative hidden lender. The presence of the hidden lender allows borrowers to conceal poor results from their banks and, thus, restricts the contracts that can be obtained from the banking sector and reduces welfare. In equilibrium, some borrowers obtain funds from both the banking sector and the inefficient hidden lender simultaneously; cross-subsidies arise between different borrowers and this leads to too little liquidation. Imposing distributionalassumptions, we fully characterize outcomes and show that as the cost of borrowingfrom the hidden lender increases, total welfare increases. We generalize the model toallow for a partially hidden lender and obtain qualitatively similar results.

Keywords: Long-term debt, hidden borrowing, debt contracts, adverse selection