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Financial Contracting with Enforcement Externalities

49 Pages Posted: 21 Jan 2016  

Lukasz A. Drozd

University of Pennsylvania - The Wharton School

Ricardo Serrano-Padial

University of Wisconsin-Madison, Department of Economics

Date Written: 2016-01-20

Abstract

Contract enforceability in financial markets often depends on the aggregate actions of agents. For example, high default rates in credit markets can delay legal enforcement or reduce the value of collateral, incentivizing even more defaults and potentially affecting credit supply. We develop a theory of credit provision in which enforceability of individual contracts is linked to aggregate behavior. The central element behind this link is enforcement capacity, which is endogenously determined by investments in enforcement infrastructure. Our paper sheds new light on the emergence of credit crunches and the relationship between enforcement infrastructure, economic growth, and political economy distortions.

Keywords: Enforcement, Credit rationing, Costly state verification, State capacity, Financial accelerator, Credit crunch, Global games, Heterogeneity

JEL Classification: D82, D84, D86, G21, O16, O17, O43

Suggested Citation

Drozd, Lukasz A. and Serrano-Padial, Ricardo, Financial Contracting with Enforcement Externalities (2016-01-20). FRB of Philadelphia Working Paper No. 16-1. Available at SSRN: https://ssrn.com/abstract=2719476

Lukasz A. Drozd (Contact Author)

University of Pennsylvania - The Wharton School ( email )

3641 Locust Walk
Philadelphia, PA 19104-6365
United States

Ricardo Serrano-Padial

University of Wisconsin-Madison, Department of Economics ( email )

1180 Observatory Drive
Madison, WI 53706
United States

HOME PAGE: http://www.ssc.wisc.edu/~rserrano/

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