A relational theory of relationship lending under contractual incompleteness

Joao M. De Mello, PUC-Rio
Vinicius Carrasco, PUC-Rio

Abstract

We consider a model of repeated (relationship) lending in which some contingencies that are relevant for a bank’s decision to finance a project cannot be described contractually. The hazards related to this lack of contractibility can be magnified by actions taken by an entrepreneur. The continuation value of a lending relationship induces borrowers to take actions that minimize the ex-post conflict of interests resulting from contractual incompleteness. The optimal lending relationship is stationary on the equilibrium path. A robust feature of an optimal lending relationship is that the action schedule (as a function of project types) adopted by the entrepreneur is either a constant or a step function. Hence, the bank imposes to the entrepreneur a finite set of decisions from which he can pick his action, bounding his discretion over decisions. This leads to lower interest rates charged by the bank and to efficient refinancing in a lending relationship when compared to arm’s length financing.