Long-Term Debt and Hidden Borrowing

Abstract

We consider borrowers with the opportunity to raise funds from a competitive banking sector that shares information, as well as from other hidden lenders. The presence of hidden lenders allows borrowers to conceal poor results from their banks and, thus, restricts the contracts that can be obtained from the banking sector. In equilibrium, borrowers obtain funds from both the banking sector and ine¢ cient hidden lenders simultaneously, so that different types of borrowers cannot be distinguished by banks. This generates cross-subsidies between different borrowers that are observationally equivalent to the banking sector. We show that the cheaper the cost of hidden borrowing, the lower is welfare and the lower is the variety of funding arrangements in the banking sector. In particular, while high costs of hidden borrowing allow each different (viable) type of borrower to access different terms from the banking sector, as the cost of hidden borrowing falls, more and more borrowers face identical terms up to the point where all borrowers who access the banking sector (which may include inefficient ones) face identical terms. We generalize the model to allow for partially-hidden lenders and obtain qualitatively similar results.

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