Long Term Debt with Hidden Borrowing

Abstract

We consider borrowers with the opportunity to raise funds from a competitive banking sector that shares information about borrowers, and an alternative hidden lender. We highlight that the presence of the hidden lender restricts the contracts that can be obtained from the banking sector and that in equilibrium some borrowers obtain funds from both the banking sector and the (inefficient) hidden lender simultaneously. We further show that as the inefficiency of the hidden lender increases, total welfare decreases. By extending the model to examine a partially hidden lender, we further highlight the key role of information.

Keywords: Long term debt, hidden borrowing, debt contracts, adverse selection

JEL Classification: D82, D14, G21, D86