Discretionary Contracts and Bank-Firm Relationships

Abstract

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