Financial Contracting with Enforcement Externalities

Drozd, Lukasz A.; Serrano-Padial, Ricardo

doi:https://doi.org/10.21799/frbp.wp.2018.21

Working Paper

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.

Keywords: contract enforcement; default spillovers; credit crunch; credit cycles; global games; heterogeneity;

JEL Classification: C72; D82; D84; D86; G21; O16;

https://doi.org/https://doi.org/10.21799/frbp.wp.2018.21