«IZA DP No. 4351 Reputation and Credit Market Formation: PAPER How Relational Incentives and Legal Contract Enforcement Interact Ernst Fehr DISCUSSION ...»
B. Reputation and Third Party Enforcement of Repayments In the previous section we have seen that reputation formation opportunities go a long way towards solving the double moral hazard problem in our credit market. In this section we examine how credit markets are affected if one of the two moral hazard problems – the repayment problem – is solved by legal enforcement. A first intuition might lead one to believe that if only the project choice problem remains, it might be easier to solve this problem with reputational incentives. However, as we have seen in Section III.B, the introduction of third party enforcement might exacerbate the project choice problem. Our next result shows that this is indeed the case.
Result 5 (market trading and project choice under third party enforcement): The introduction of third party enforcement of debt repayment causes a further significant increase in the number of trades but it also leads to a significant reduction in the share of efficient projects so that the efficiency gains from third party enforcement are relatively small.
We provide support for the first part of Result 5 by means of Figure II. This figure indicates that in almost all periods the share of realized contracts is higher in the third party condition (TPC) than in the RC. This difference is also statistically significant according to a Mann Whitney test with session averages as the unit of observation (p = 0.008)18. However, the realized gains from trade are only somewhat higher in the TPC compared to the RC – 72% in the TPC and 66% in the RC. Moreover, this difference is not statistically significant (Mann Whitney test with session averages as unit of observations, p = 0.247).
If efficiency does not increase although the number of trades is significantly higher in the TPC, project choices must differ across conditions. Our theoretical analysis in Section III.B (see page 15) suggests that borrowers may face weaker incentives to choose project A in the TPC than in the RC. And indeed, in more than half of the trades (54%) the borrowers choose the inefficient project B in the TPC while in the RC the borrowers choose project B in only 9% of the cases. This difference is highly significant (Mann Whitney test with session averages as unit of observations, p = 0.004).
One important reasons why the borrowers choose the inefficient project much more often in the TPC than in the RC is that the borrowers in the TPC face much stronger shortterm incentives to choose project B. Due to the legal enforceability of debt repayments, the choice of project B always maximized the borrowers’ period profit in the TPC. In the RC, in contrast, this was not the case. Despite the fact that reputational forces greatly alleviated the repayment problem in the RC, borrowers did still not repay anything in 17.5% percent of the successful projects. In these 17.5 % of the cases, the borrower had the incentive to choose the We also ran several regressions with the realized number of trades as the dependent variable, a treatment dummy for RC and various dummy variables for different time intervals and interactions between time intervals and the treatment dummy. All these regressions reveal the same picture: the TPC significantly increases the number of trades.
efficient project A because he earned the whole project return. Furthermore, lenders in the TPC requested much higher repayments in case of a project success than in the RC which increases the short term incentive to choose project B. Thus, even in the cases where they planned to make the repayment requested by the lender, borrowers in the RC had less strong incentives to choose project B than the borrowers in the TPC. In Table III we show how much borrowers can gain if they choose project B although the lender asks for project A in the RC and the TPC. The table illustrates that the difference in the borrowers’ expected profits between project A and B differs substantially across conditions. The relative short term attractiveness of project B – as measured by the expected profit of project B relative to project A – is considerably higher in the TPC than in the RC.
Insert Table III about here
Table III is based on data from contracts in which the lender’s desired project is project A. The table displays expected period profits of borrowers for each possible project choice.19 In trades carried out by a lender and a borrower who interact infrequently with each other (1-3 times over the experiment) choosing project A yields a slightly higher expected profit for the borrower in the RC while project B yields a much higher expected profit in the TPC. If a pair of traders interacted repeatedly with each other (between 4 and 10 times or between 11 and 20 times, respectively) project B yields higher expected payoffs for borrowers both in the RC and the TPC. However, the difference in expected profits between the two projects is much larger in the TPC, indicating that borrowers have a stronger short-term incentive to choose project B in the TPC than in the RC. Thus, for given reputational incentives (arising from contingent contract renewals) the borrowers have stronger incentives to choose the inefficient project B in the TPC.
The fact that the introduction of third party enforcement exacerbates the project choice problem implies that the provision of reputational incentives may still be of high value in the TPC. Since a borrower can increase the probability of repayment by choosing the efficient project, the lenders can provide reputational incentives to choose project A by making contract renewals dependent on past repayment behavior. Our next result addresses, therefore, In the TPC the fact that desired repayments are enforceable makes it easy to calculate borrowers’ expected profits. The database consists of all concluded contracts in which the lender desired project A. Expected profits are calculated as: Expected profit = Probability of success x (Project return – Desired repayment). In the RC, in contrast, the desired repayment is not binding and the borrower can repay as much as he wants. In this case the data base consists of all accepted contracts in which the lender desired project A and the borrower successfully completed a project (either A or B). Expected profits are calculated as: Expected profit = Probability of success x (Project return - Observed repayment). We can only consider contracts with successful projects because intended repayments are not observable in case of project failure. As project success is random, this does not bias our results. Our calculations for the RC implicitly assume that borrowers would have made the same repayment, if they had chosen the other project. The data support this assumption: the borrower’s actual project choice does not significantly affect the repayment level in contracts in which the lender desired project A. This makes sense, if we take into account that borrowers have always incentives to pretend that they have chosen project A.
the question whether borrowers face such reputational incentives in the TPC and how strong they are in comparison to the RC Result 6 (endogenous enforcement of efficient project choices): Under third party enforcement of repayments the lenders condition contract renewal on the borrower’s past repayment behavior but the impact of past repayments on contract renewal is weaker than in the RC. Nevertheless, contingent contract renewal also leads to repeated interactions between borrowers and lenders in the TPC.
Result 6 means that the borrowers in the TPC do not only face stronger short-term incentives to choose the inefficient project but they also face weaker reputational incentives to choose the efficient project A. Taken together these facts provide a plausible explanation for why we observe much fewer efficient project choices in the TPC.
Support for Result 6 comes from Table IV which shows probit regressions with data from the TPC and the RC in which the binary variable “contract renewal in the next period” is the dependent variable. Regressions 1 and 2 compare the impact of the current repayment, the average repayment in previous interactions with the same lender and the number of previous interactions with the same lender on the probability of a contract renewal in the next period.
The corresponding ME-columns report the marginal effects.20 The significantly negative interaction effect of the TP dummy and the current repayment level (see columns ME and ME) indicates that the current repayment level has a weaker positive impact on the probability of contract renewal in the next period. Regressions 3 and 4 confirm this finding with a different set of right-hand side variables. Instead of current and past repayment levels we use a dummy for positive current repayments and the percentage of positive repayments in previous interactions as regressors. In both regressions the interaction between the dummy for positive repayments and the TPC dummy is negative, significant and sizeable. This result means a positive repayment in the TPC did not increase a borrower’s chances of a contract renewal in the same way as in the RC: a positive repayment in period t increases the chances of a contract renewal in the TPC by about 10 to 13 percentage points less than in the RC. This implies that that there are less strong incentives to choose the low risk project A in the TPC than in the RC.
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Since the interaction effect does not correspond to the marginal effect of the interaction term in non-linear estimations, we used the procedure recommended by Ai and Norton (2003) to estimate the correct interaction effects.
Yet, despite this decrease in contingency of contract renewals the borrowers in the TPC still face reputational incentives. A positive repayment increases the probability of a contract renewal by about 30 percentage points (see columns ME and ME). That these incentives have important consequences for the prevalence of repeated interactions in the TPC is illustrated by the fact that the cumulative frequency of trades in the TPC – which is shown in Figure VI – resembles the one in the RC: a substantial share of the trades is executed by trader pairs that interact many times with each other.
Insert Figure VI about here
The lower degree of contingency in contract renewals also does not mean that contingent contract renewal did not have an effect on project choices and average repayments.
Figure VII shows that in relations lasting more than 10 periods project A was chosen in more than 70 percent of the cases and the average repayments were therefore, rather high. Yet, in relations that lasted less than 10 periods the efficient project is only chosen in less than 40% of the cases. As a consequence, borrowers and lenders benefited from the establishment of long-term relations: if we regress profits on the intensity of repeated interactions (IRI) in the TPC we observe that a higher IRI is associated with higher profits for both lenders and borrowers (lenders: coefficient = 14.42, p = 0.006, robust standard errors clustered on session level; borrowers: coefficient = 24.51, p = 0.021, robust standard errors clustered on session level).
In this paper we experimentally investigate how reputation formation in endogenously built relationships affects credit market performance and how these relational incentives interact with improvements in the legal enforceability of debt repayments. When legal institutions are weak and repayments cannot be exogenously enforced we find that the disciplining effect of relational incentives is a decisive determinant for the existence and functioning of credit markets. In the condition where reputation formation opportunities are exogenously excluded the lack of repayment incentives leads to a breakdown of credit market activity. However, when we allow that borrowers can acquire a reputation, stable credit markets emerge in which roughly 80% of all feasible trades take place. By conditioning access to future credits on previous debt repayments, lenders create powerful incentives for borrowers to repay their debt out of reputational concerns. Borrowers respond to these incentives by choosing efficient projects and a high repayment rate. As a consequence, many mutually beneficial trades take place.
This finding is interesting with regard to the literature on relationship banking.
Theoretically, it has often been argued that the prevalence of bilateral borrower-lender relationships may be due to the disciplining effect of contingent contract renewals. However, so far existing field data has not allowed separating this effect from the alternative explanation that relationships are attractive because they provide lenders with better access to the borrower’s books and therewith lead to the selection of better borrowers. Our experiment enables us to show the positive impact of the disciplining effect on credit market performance in a clean and controlled way.
When the legal credit market environment improves, we observe an interesting interaction effect between relational incentives and the exogenous enforcement of debt repayments. While the legal enforceability of debt repayment causes a significant increase in credit market trading, it has only a small positive impact on credit market efficiency. The reason is that in the presence of limited liability and wealth constraints the legal enforcement of debt repayments motivates many borrowers to choose inefficiently risky projects.
Endogenous contract enforcement in relationships does only partly offset this effect. Thus, legal enforcement provides not only a powerful solution to the moral hazard problem associated with debt repayment, but it also exacerbates the moral hazard problem that is associated with the incentive to choose inefficient high risk projects.
To the best of our knowledge, the possibility that legal enforcement weakens reputational incentives and increases the frequency of inefficient project choices has not been discussed before. Our finding that legal and endogenous enforcement mechanisms may have important interactions suggests that these effects should be studied more extensively in future work.