Discretionary Contracts and Bank-Firm Relationships

14th Annual Conference on Financial Economics and Accounting (FEA)

41 Pages Posted: 9 Feb 2004

See all articles by Anjolein Schmeits

Anjolein Schmeits

New York University (NYU) - Leonard N. Stern School of Business; New York University (NYU) - Department of Finance

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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.

Suggested Citation

Schmeits, Anjolein B., Discretionary Contracts and Bank-Firm Relationships (January 12, 2003). 14th Annual Conference on Financial Economics and Accounting (FEA), Available at SSRN: https://ssrn.com/abstract=488104 or http://dx.doi.org/10.2139/ssrn.488104

Anjolein B. Schmeits (Contact Author)

New York University (NYU) - Leonard N. Stern School of Business ( email )

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New York University (NYU) - Department of Finance ( email )

Stern School of Business
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New York, NY 10012-1126
United States