Financial Contracting with Enforcement Externalities
Abstract: 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.
File(s): File format is application/pdf https://www.philadelphiafed.org/-/media/frbp/assets/working-papers/2018/wp18-21.pdf
Provider: Federal Reserve Bank of Philadelphia
Part of Series: Working Papers
Publication Date: 2018-10-18
Pages: 54 pages