Lending with Costly Enforcement of Repayment and Potential Fraud

22 Pages Posted: 9 Jun 2004 Last revised: 23 Aug 2010

See all articles by Jonathan Eaton

Jonathan Eaton

Leonard N. Stern School of Business - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: September 1985

Abstract

If contracts are costlessly enforcible then insolvency is the only reason for nonrepayment of loans. While some models have examined the borrower's incentive to repay, it has typically been assumed that the penalty suffered by a debtor in default is imposed automatically and without cost to the lender. If in fact invoking a penalty is costly, Pareto-improving loans may be dynamically inconsistent not because of the absence of a sufficiently harsh penalty for default, but because the lender has no incentive actually to implement the penalty in the event of default. In such situations infinitely-lived institutions can emerge as banking intermediaries between lenders and borrowers. These institutions, repeatedly involved in lending, have an incentive to enforce contracts that individual lenders lack. They can consequently sustain more lending. For their reputations as enforcers of contracts to have value requires that banks earn strictly positive profits. Maintaining the value of bank equity also provides an incentive for bankowners to invest deposits rather than to use these funds fraudulently. Because of the supernormal profits that banks must earn, an equilibrium that is sustained by bank reputation will not replicate an equilibrium in which loan repayment is automatically guaranteed.

Suggested Citation

Eaton, Jonathan, Lending with Costly Enforcement of Repayment and Potential Fraud (September 1985). NBER Working Paper No. w1697. Available at SSRN: https://ssrn.com/abstract=338775

Jonathan Eaton (Contact Author)

Leonard N. Stern School of Business - Department of Economics ( email )

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