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A Dynamic Model of Unsecured Credit

A Dynamic Model of Unsecured Credit

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The author studies the terms of credit in a competitive market in which sellers (lenders) are willing to repeatedly finance the purchases of buyers (borrowers) by engaging in a credit relationship. The key frictions are: (i) the lender is unable to observe the borrower's ability to repay a loan; (ii) the borrower cannot commit to any long-term contract; (iii) it is costly for the lender to contact a borrower and to walk away from a contract; and (iv) transactions within each credit relationship are not publicly observable. The lender's optimal contract has two key properties: delayed settlement and debt forgiveness. Asymmetric information gives rise to the property of delayed settlement, which is a contingency in which the lender allows the borrower to defer the repayment of his loan in exchange for more favorable terms of credit within the relationship. This property, together with the borrowers' lack of commitment, gives rise to debt forgiveness. When the borrower's participation constraint binds, the lender needs to "forgive" part of the borrower's debt to keep him in the relationship. Finally, the author studies the impact of the changes in the initial cost of lending on the terms of credit.
The author studies the terms of credit in a competitive market in which sellers (lenders) are willing to repeatedly finance the purchases of buyers (borrowers) by engaging in a credit relationship. The key frictions are: (i) the lender is unable to observe the borrower's ability to repay a loan; (ii) the borrower cannot commit to any long-term contract; (iii) it is costly for the lender to contact a borrower and to walk away from a contract; and (iv) transactions within each credit relationship are not publicly observable. The lender's optimal contract has two key properties: delayed settlement and debt forgiveness. Asymmetric information gives rise to the property of delayed settlement, which is a contingency in which the lender allows the borrower to defer the repayment of his loan in exchange for more favorable terms of credit within the relationship. This property, together with the borrowers' lack of commitment, gives rise to debt forgiveness. When the borrower's participation constraint binds, the lender needs to "forgive" part of the borrower's debt to keep him in the relationship. Finally, the author studies the impact of the changes in the initial cost of lending on the terms of credit.

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Published by: Federal Reserve Bank of Philadelphia on Feb 02, 2011
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WORKING PAPER NO. 11-2A DYNAMIC MODEL OF UNSECURED CREDIT
 Daniel R. SanchesFederal Reserve Bank of PhiladelphiaDecember 2010
 
 A Dynamic Model of Unsecured Credit
Daniel R. SanchesFederal Reserve Bank of PhiladelphiaDecember 2010I thank Steve Williamson, Gaetano Antinolfi, James Bullard, Rody Manuelli, Thorsten Koeppl,Cyril Monnet, William Roberds, Pedro Gomis-Porqueras, Randy Wright, Costas Azariadis,David Andolfatto, and Mitchell Berlin for helpful comments. I also thank participants at the 2ndEuropean Economic Review Talented Economists Clinic in Florence, the 2009 SummerWorkshop on Money and Banking at the Federal Reserve Bank of Chicago, and the Search andMatching Workshop at the Federal Reserve Bank of Philadelphia. Finally, I would like to thank seminar participants at the Federal Reserve Bank of Richmond, Federal Reserve Bank of Philadelphia, University of Kansas, University of Toronto, Federal Reserve Board, Bank of Canada, University of Miami, PUC-Rio, and FGV-EPGE.Correspondence to Sanches at Research Department, Federal Reserve Bank of Philadelphia, TenIndependence Mall, Philadelphia, PA 19106-1574; phone: (215) 574-4358; Fax: (215) 574-4303;e-mail:Daniel.Sanches@phil.frb.org.The views expressed in this paper are those of the author and do not necessarily reflect those of the Federal Reserve Bank of Philadelphia or the Federal Reserve System. This paper is availablefree of charge at www.philadelphiafed.org/research-and-data/publications/working-papers/ 
 
Abstract
We study the terms of credit in a competitive market in which sellers (lenders) arewilling to repeatedly …nance the purchases of buyers (borrowers) by engaging in a creditrelationship. The key frictions are: (i) the lender is unable to observe the borrower’sability to repay a loan; (ii) the borrower cannot commit to any long-term contract;(iii) it is costly for the lender to contact a borrower and to walk away from a contract;and (iv) transactions within each credit relationship are not publicly observable. Thelender’s optimal contract has two key properties: delayed settlement and debt forgive-ness. Asymmetric information gives rise to the property of delayed settlement, which isa contingency in which the lender allows the borrower to defer the repayment of his loanin exchange for more favorable terms of credit within the relationship. This property,together with the borrowers’ lack of commitment, gives rise to debt forgiveness. Whenthe borrower’s participation constraint binds, the lender needs to “forgive” part of theborrower’s debt to keep him in the relationship. Finally, we study the impact of thechanges in the initial cost of lending on the terms of credit.Keywords: Unsecured Loans; Dynamic Contracting; Delayed Settlement; Debt For-giveness; Initial Cost of Lending. JEL Classi…cation Numbers: D8, E4, G2.
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