Discretionary Contracts and Bank-Firm Relationships

OLIN Working Paper No. 2002-08-002

40 Pages Posted: 18 Nov 2002

See all articles by Anjolein Schmeits

Anjolein Schmeits

New York University (NYU) - Leonard N. Stern School of Business; New York University (NYU) - Department of Finance

Multiple version iconThere are 2 versions of this paper

Date Written: June 20, 2002


This paper provides a rationale for the use of discretion in bank loan contracts. Discretion allows banks which produce information on borrowers to optimally adapt contract terms to 'soft' or non-verifiable information in the course of lending. This facilitates investment efficiency and also allows for wealth redistributions in favor of firms with good investment opportunities. I show that the optimality of discretion depends critically on bank quality and the degree of lender competition. If bank quality is low and/or lender competition is limited, enforceable bank contracts and financial market contracts dominate discretionary contracts. Moreover, I show that the relative importance of bank vis-a-vis financial market financing is non-monotonic in borrower quality. The analysis has implications for the competitive position of banks and emphasizes the value of relationship lending in an increasingly competitive environment.

Keywords: Banking, Financial Contracting, Relationship-Lending

JEL Classification: G21, G32

Suggested Citation

Schmeits, Anjolein B., Discretionary Contracts and Bank-Firm Relationships (June 20, 2002). OLIN Working Paper No. 2002-08-002, Available at SSRN: https://ssrn.com/abstract=323240 or http://dx.doi.org/10.2139/ssrn.323240

Anjolein B. Schmeits (Contact Author)

New York University (NYU) - Leonard N. Stern School of Business ( email )

44 West 4th Street
Suite 9-160
New York, NY NY 10012
United States

New York University (NYU) - Department of Finance ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States

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