Evidence for Dynamic Contracts in Sovereign Bank Lending
31 Pages Posted: 21 Apr 2011
Date Written: April 1, 2011
Abstract
This paper presents direct evidence for self-enforcing dynamic contracts in sovereign bank lending. Unlike the existing empirical literature, its instrumental variables method allows for distinguishing a direct influence of past repayment problems on current spreads (a punishment effect in prices) from an indirect effect through higher expected future default probabilities. Such a punishment provides positive surplus to lenders after a default, a feature that characterizes dynamic contracts. Using data on bank loans to developing countries between 1973-1981 and constructing continuous variables for credit history, we find evidence that most of the influence of past repayment problems is through the direct, punishment channel.
Keywords: reputation, dynamic contracts, sovereign bank loan spreads, rational expectations, default risk
JEL Classification: C73, D86, F34, G12, G14, G15
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