Implicit Benefits and Financing

Abstract

Social relationship and business connections create implicit benefits between borrowers and lenders. We model how implicit benefits and repayment enforcement costs influence credit allocation, cost, and renegotiation. The optimal solution illustrates that financing with implicit benefits can in many circumstances achieve lower financing costs, higher managerial effort, and better economic outcomes for both the borrower and the lender. This result explains the continuing expansion of alternative financing despite advanced formal financial intermediation, the rise of corporate insider debt, and joint ownership of debt and equity. The growing size and complexity of projects and changes in community relationships explain the expansion of bank financing.

Keywords: Implicit benefits, debt financing, banks, corporate insider debt, joint equity-debt ownership, social and business networks

JEL Classification: G21 G23 D02