1. THE BORROWER-LENDER RELATIONSHIP

2. AGENDA 4 THE RISK SHARING APPROACH 4 COSTLY STATE VERIFICATION 4 INCENTIVES TO REPAY 4 INCOMPLETE CONTRACTS 4 DISCRIMINATING AMONG BORROWERS

3. THE COMPLEXITY OF CONTINGENT CONTRACTS 4 Repayments (Additional loans) 4 Collateral 4 The borrower’s actions (investment)

4. THE STANDARD DEBT CONTRACT 4 definition: 4 repayment is independent of cash flows 4 If the cash flows are insufficient, all assets go to the lenders 4 If cash flows are insufficient, lenders get control of the firm

5. THE RISK SHARING APPROACH 4 Assume cash flows are risky but there is no asymmetric information 4 How is the optimal contract characterised? 4 For every cash flow, borrower and lender marginal utilities have to maintain a fixed ratio

6. COSTLY STATE VERIFICATION 4 Observation of the borrower’s cash flows is costly (auditing cost) 4 The contract can be designed so that depending on the repayment the borrower is audited or not. 4 Minimisation of the auditing costs leads to the Standard Debt Contract.

7. CASH FLOWS REPAYMENTS

8. DRAWBACKS 4 Is the audit threat credible? Should not renegotiation be introduced? 4 Random auditing with high penalties may be more efficient

9. Legal enforcement

10. 4 Recovery rates 4 No strategic default 4 Equilibrium:

11. Implications 4 Inefficient investment –Notice that a lower recovery rate on cash flows will lead to collateral based lending 4 Low legal enforcement (high borrower protection?) lead to lower levels of finance.

12. INCENTIVES TO REPAY 4 Cash flows observation is infinitely costly 4 The incentives to repay may come from the benefits of receiving funding in the future.

13. INCENTIVES TO REPAY: 4 BOLTON-SHARFSTEIN 4 SOVEREIGN DEBT

14. BOLTON-SHARFSTEIN(I) 4 Zero interest rates, risk neutral agents 4 A project may have a high or low non verifiable cash flow 4 In a one period contract, the borrower will pretend the low cash flow has obtained 4 As a consequence credit market would not exist

15. BOLTON-SHARFSTEIN(II) 4 In the two period case the lender may promise additional funding to the borrowers that have repaid and no funding to the defaulting ones 4 The incentives to repay for a successful firm are now :

16. BOLTON-SHARFSTEIN(III) 4 In the dynamic case, a market for loans may develop because the threat of termination may provide the right incentives 4 The bank promise to provide additional funding has to be credible

17. SOVEREIGN DEBT(I) 4 A simple model (Allen 1983) 4 The country’s profit are:

18. SOVEREIGN DEBT(II) 4 In an infinite horizon the present value of being denied credit by the borrower is:

19. SOVEREIGN DEBT(III) 4 Credit rationing? 4 Bullow Rogoff argument

20. INCOMPLETE CONTRACTS 4 EX ANTE DESIGN AND EX POST RENEGOTIATION 4 CASH FLOWS VS. PLEDGEABLE CAS H FLOWS

21. DISCRIMINATING AMONG BORROWERS 4 ASYMMETRIC INFORMATION AND MECHANISM DESIGN 4 COLLATERAL AND REPAYMENT 4 LOAN SIZE AND REPAYMENT