AN ECONOMIC PERSPECTIVE ON THE ENFORCEMENT OF CREDIT ARRANGEMENTS: THE CASE OF DAYLIGHT OVERDRAFTS IN FEDWIRE

Economic Policy Review - Federal Reserve Bank of New York, Sep 2008 by Martin, Antoine, Mills, David C

Information that is either unobservable or unverifiable is typically called private-as opposed to public information, which is both observable and verifiable. Economists therefore classify contractual situations as either of two types: 1) those in which perfect enforcement is possible because all relevant information is publicly available and 2) those in which there is only imperfect or costly enforcement because at least some relevant information is private.

2.4 Enforcing Contracts through Reputation, Monitoring, and Collateral

The information frictions described above can create credit risk over and above the risk that might come only from bad luck. Because of information frictions, a more sophisticated policy than simply charging an interest rate for a loan might be necessary. As we observed, when credit risk arises only from bad luck, no additional policy is necessary because nothing can be done to affect the probability that the loan will be repaid.

In principle, there are several ways to alleviate enforcement problems, and each method is costly. Because enforcement is not perfect, a trade-off always exists between better enforcement of contract terms and more costly means of ensuring enforcement. Among the ways of enforcing contracts in situations of imperfect information are reputation, monitoring, and collateral. We consider each of them in turn and provide an example of how a loan for a construction project uses all three.

Reputation

In cases of repeated interactions, the terms of a contract can depend on past actions. Borrowers can obtain better terms by establishing a reputation for good behavior. Reputation is achieved by showing a willingness to refrain from shortterm opportunism. Reputation can be thought of as a way to make private information about one's type more public. In particular, it signals to a potential lender that a borrower is more interested in long-term outcomes (possibly because he or she wants to avoid punishments that restrict access to future loans) than any short-term gains achieved by defaulting on a loan. Reputation, therefore, can typically alleviate problems associated with adverse selection. In the case of a construction loan, a building contractor who wants to finance a new project may rely on reputation in negotiating terms for a new loan. A solid credit history increases the contractor's chances of securing a new loan and allows him to negotiate favorable terms.

Monitoring

Lenders can prevent opportunism by closely monitoring borrowers' actions, by screening and certifying their quality and that of their project, or, after a default, by verifying the quality and amount of their assets and operations. Monitoring can be thought of as a way to acquire information that would otherwise be private. As a result, monitoring can typically help alleviate the incentive issues associated with both moral hazard and adverse selection. In monitoring construction loans, for example, lenders conduct periodic inspections and require status reports from the contractor or independent third parties as a way to keep track of the project's progress.