Federal Reserve Bank of Philadelphia
Financial Contracting with Enforcement Externalities
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.
Cite this item
Lukasz A. Drozd & Ricardo Serrano-Padial, Financial Contracting with Enforcement Externalities, Federal Reserve Bank of Philadelphia, Working Papers 18-21, 18 Oct 2018.
- C72 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Noncooperative Games
- D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
- D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
- D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
- G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
- O16 - Economic Development, Innovation, Technological Change, and Growth - - Economic Development - - - Financial Markets; Saving and Capital Investment; Corporate Finance and Governance
Keywords: contract enforcement; default spillovers; credit crunch; credit cycles; global games; heterogeneity
This item with handle RePEc:fip:fedpwp:18-21
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