Financial Contracting with Enforcement Externalities

54 Pages Posted: 22 Oct 2018 Last revised: 29 Apr 2020

See all articles by Lukasz Drozd

Lukasz Drozd

Federal Reserve Banks - Federal Reserve Bank of Philadelphia

Ricardo Serrano-Padial

Drexel University, School of Economics

Date Written: 2018-10-18

Abstract

We study the negative feedback loop between the aggregate default rate and the efficacy of enforcement in a model of debt-financed entrepreneurial activity. The novel feature of our model is that enforcement capacity is accumulated ex ante and thus subject to depletion ex post. We characterize the effect of shocks that deplete enforcement resources on the aggregate default rate and credit supply. In the model default decisions by entrepreneurs are strategic complements, leading to multiple equilibria. We propose a global game selection to overcome equilibrium indeterminacy and show how shocks that deplete enforcement capacity can lead to a spike in the aggregate default rate and trigger credit rationing.

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

JEL Classification: C72, D82, D84, D86, G21, O16

Suggested Citation

Drozd, Lukasz and Serrano-Padial, Ricardo, Financial Contracting with Enforcement Externalities (2018-10-18). FRB of Philadelphia Working Paper No. 18-21, Available at SSRN: https://ssrn.com/abstract=3269695 or http://dx.doi.org/https://doi.org/10.21799/frbp.wp.2018.21

Lukasz Drozd (Contact Author)

Federal Reserve Banks - Federal Reserve Bank of Philadelphia

Ricardo Serrano-Padial

Drexel University, School of Economics ( email )

3220 Market St
Philadelphia, PA 19104
United States

HOME PAGE: http://www.serrano-padial.com

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