Credit Enforcement Cycles

Abstract

Empirical evidence suggests that widespread financial distress, by disrupting enforcement of credit contracts, can be self-propagatory and adversely affect the supply of credit. We propose a unifying theory that models the interplay between enforcement, borrower default decisions, and the provision of credit. The central tenets of our framework are the presence of capacity constrained enforcement and borrower heterogeneity. We show that, despite heterogeneity, borrowers tend to coordinate their default choices, leading to fragility and to credit rationing. Our model provides a rationale for the comovement of enforcement, default rates and credit seen in the data.

Keywords: contract enforcement, enforcement capacity, default spillovers, credit crunch, credit cycles, global games, heterogeneity

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