Working Paper

Financing Repeat Borrowers: Designing Credible Incentives for Today and Tomorrow

Abstract: We analyze relational contracts between a lender and borrower when borrower cash flows are not contractible and the costs of intermediation vary over time. Because lenders provide repayment incentives to borrowers through the continuation value of the lending relationship, borrowers will condition loan repayment on the likelihood of receiving loans in the future. Therefore, the borrower's beliefs about the lender's future liquidity and profitability become an important component of the borrower's repayment decision. Consequently, the possibility of high lending costs in the future weakens repayment incentives and can cause the borrower to strategically default in some states and an inefficient under-provision of credit. We characterize the optimal relational contract and discuss the application of our model to the case of microfinance and trade credit.

Keywords: trade credit; dynamic incentives; relationship lending; microfinance; repeated games;

JEL Classification: O16; G33; G21;

https://doi.org/10.17016/IFDP.2022.1364

Bibliographic Information

Provider: Board of Governors of the Federal Reserve System (U.S.)

Part of Series: International Finance Discussion Papers

Publication Date: 2022-12

Number: 1364