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Federal Reserve Bank of Philadelphia
Working Papers
Financial Contracting with Enforcement Externalities
Lukasz A. Drozd
Ricardo Serrano-Padial

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.

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Lukasz A. Drozd & Ricardo Serrano-Padial, Financial Contracting with Enforcement Externalities, Federal Reserve Bank of Philadelphia, Working Papers 18-21, 18 Oct 2018.
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Keywords: contract enforcement; default spillovers; credit crunch; credit cycles; global games; heterogeneity
DOI: https://doi.org/10.21799/frbp.wp.2018.21
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