Working Paper

Financial contracting with enforcement externalities

Abstract: Contract enforceability in financial markets often depends on the aggregate actions of agents. For example, high default rates in credit markets can delay legal enforcement or reduce the value of collateral, incentivizing even more defaults and potentially affecting credit supply. We develop a theory of credit provision in which enforceability of individual contracts is linked to aggregate behavior. The central element behind this link is enforcement capacity, which is endogenously determined by investments in enforcement infrastructure. Our paper sheds new light on the emergence of credit crunches and the relationship between enforcement infrastructure, economic growth, and political economy distortions.

Keywords: Enforcement; Credit rationing; Costly state verification; State capacity; Financial accelerator; Credit crunch; Global games; Heterogeneity;

JEL Classification: D82; D84; D86; G21; O16; O17; O43;

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Bibliographic Information

Provider: Federal Reserve Bank of Philadelphia

Part of Series: Working Papers

Publication Date: 2016-01-20

Number: 16-1

Pages: 49 pages