Discretionary Contracts and Bank-Firm Relationships
14th Annual Conference on Financial Economics and Accounting (FEA)
41 Pages Posted: 9 Feb 2004
There are 2 versions of this paper
Discretionary Contracts and Bank-Firm Relationships
Date Written: January 12, 2003
Abstract
This paper provides a rationale for the use of discretion in bank loan contracts. Discretion allows banks which produce information on borrowers to optimally adapt contract terms to 'soft' or non-verifiable information in the course of lending. This facilitates investment efficiency and also allows for wealth redistributions in favor of firms with good investment opportunities. I show that the optimality of discretion depends critically on bank quality and the degree of lender competition. If bank quality is low and/or lender competition is limited, enforceable bank contracts and financial market contracts dominate discretionary contracts. I also show that the relative importance of bank vis-a-vis financial market financing is non-monotonic in borrower quality. The analysis has implications for the competitive position and the optimal organizational structure of banks, and emphasizes the value of relationship lending in an increasingly competitive environment.
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