Reputation and Credit Market Formation: How Relational …

 

 

Reputation and Credit Market Formation:
How Relational Incentives and Legal
Contract Enforcement Interact

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IZA DP No. 4351

Ernst Fehr
Christian Zehnder

August 2009

Forschungsinstitut
zur Zukunft der Arbeit
Institute for the Study
of Labor

Reputation and Credit Market Formation:
How Relational Incentives and Legal
Contract Enforcement Interact

Ernst Fehr
University of Zurich
and IZA

Christian Zehnder
University of Lausanne

Discussion Paper No. 4351
August 2009

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IZA Discussion Paper No. 4351
August 2009

ABSTRACT

Reputation and Credit Market Formation:
How Relational Incentives and Legal Contract Enforcement Interact*

The evidence suggests that relational contracting and legal rules play an important role in
credit markets but on the basis of the prevailing field data it is difficult to pin down their causal
impact. Here we show experimentally that relational incentives are a powerful causal
determinant for the existence and performance of credit markets. In fact, in the absence of
legal enforcement and reputation formation opportunities the credit market breaks down
almost completely while if reputation formation is possible a stable credit market emerges
even in the absence of legal enforcement of debt repayment. Introducing legal enforcement
of repayments causes a further significant increase in credit market trading but has only a
surprisingly small impact on overall efficiency. The reason is that legal enforcement of debt
repayments weakens relational incentives and exacerbates another moral hazard problem in
credit markets – the choice of inefficient high-risk projects.

JEL Classification: C91, G21, G28, L14

Keywords:

Corresponding author:

Ernst Fehr
Institut für Empirische Wirtschaftsforschung
Universität Zürich
Blümlisalpstrasse 10
CH-8006 Zürich
Switzerland
E-mail: efehr@iew.uzh.ch

credit markets, relationship lending, reputation formation, legal enforcement

* We would like to acknowledge financial support from the Research Priority Program of the University
of Zurich on the “Foundations of Human Social Behavior” and the National Center of Competence in
Research on “Financial Valuation and Risk Management” (NCCR Finrisk). The National Centers in
Research are managed by the Swiss National Science Foundation on behalf of the federal authorities.

I. Introduction

Around the world credit markets are a major source of financing business projects (Rajan and

Zingales 1995, Djankov, McLiesh and Shleifer 2007) and it is well known that adverse

selection and moral hazard (Jaffee and Russel 1976, Stiglitz and Weiss 1981) are major

obstacles for the development of these markets. Recent work has indicated the importance of

legal rules and information sharing institutions for the functioning of credit markets (Pagano

and Japelli 1993, La Porta and Lopez de-Silanes 1997, La Porta et al. 1998, Japelli and

Pagano 2002, Lerner and Schoar 2005, Jappelli, Pagano and Bianco 2005; Djankov, McLiesh

and Shleifer 2007), while a different literature has stressed the role of relationship banking

and individual reputation mechanisms (Petersen and Rajan 1994, Berger and Udell 1995,

Boot 2000, Boot and Thakor 2000, Ongena and Smith 2000 and 2001, Degryse and Ongena

2005). However, although reputation mechanisms are relatively well understood at the

theoretical level (Sobel 1985, Fudenberg and Maskin 1986), it is very difficult to show with

field data that individual reputation formation is causally involved in relationship banking and

the endogenous enforcement of credit repayments. Furthermore, both “institutions” and

“relations” almost always simultaneously affect credit market behavior and very little is

known about how these enforcement mechanisms interact. It is not known whether

“institutions” and “relations” complement each other or whether legal enforcement “crowds

out” reputational enforcement mechanisms.

In this paper we, therefore, use the methods of experimental economics to examine

how reputation formation opportunities causally influence contract enforcement and market
efficiency in credit markets.4 In addition, our experiment allows us to study the causal impact
of legal third party enforcement of credit contracts and the interaction between legal

enforcement and the endogenous enforcement of contracts in long-term credit relations. For

this purpose, we conduct experiments in a laboratory environment in which two potential

sources of moral hazard coexist. The first source of moral hazard is the presence of

asymmetric information about project characteristics. Since lenders do not observe the project

choice, they cannot prevent borrowers from choosing inefficient high-risk projects. This

reflects the natural information asymmetry in credit markets: borrowers typically have more

and better information about their investment opportunities than lenders. The second source

for moral hazard is the absence of legal enforcement of debt repayment. This implies that

4 Laboratory experiments have a long tradition in the study of financial markets. For example, already Burell
(1951) used an experiment to investigate investment behavior in a controlled way. In the last two decades the
experimental literature has importantly contributed to a better understanding of price determination in security
and asset markets. For examples see, Ang and Schwarz (1985), Copeland and Friedman (1987, 1991), O’Brien
and Srivastava (1991), Schnitzlein (1996), Lamoureux and Schnitzlein (1997), Gneezy et al. (2003), Kluger and
Wyatt (2004), Haigh and List (2005), and Haruvy and Noussair (2006).

borrowers may escape the repayment of their loans even in case of a successfully realized

project. A lack of enforceable repayments can be interpreted as a stylized representation of the

institutional weaknesses observed in many developing and emerging credit markets but recent

evidence (Djankov et al. 2008) suggests that even in many advanced Western countries the

enforcement of debt repayment is surprisingly inefficient.

The enhanced control provided by the experimental method enables us to isolate the

pure effect of individual reputation formation in endogenously built long-term relationships

on the solution of the double moral hazard problem. We compare a treatment in which we rule

out any information about the identity of trading partners (so that no reputation can be

formed) with a treatment in which individual borrowers can acquire a reputation. A main

reason for the conduct of our experiments is that it is rarely possible to find field data in

which information about the traders’ identity varies exogenously. Therefore, field data do

typically not allow for the clean identification of the extent to which reputational incentives

are causally involved in solving the moral hazard problems inherent in credit markets.

Once we have identified the pure reputation effect on credit market functioning, we

are in a position to study the interaction between legal enforcement of credit repayment and

reputational incentives. We do this by implementing third party enforcement of credit

repayments under conditions of limited liability and wealth constraints for the borrowers. In

particular, the third party can force the borrower to repay his loan if the borrower’s project

turns out to be successful but if the project fails no repayment can be enforced because

borrowers have no wealth that could be taken away from them. While third party enforcement

resolves the credit repayment problem, the borrowers still have the possibility to choose

inefficient high risk projects. This may be attractive because limited liability implies that they

can shift part of the project risk on the lenders. We believe that this set-up characterizes the

situation in many advanced Western economies in which borrowers’ cannot easily escape

their legal obligations to repay their debt if they have resources that can be taken away from

them but once their projects fail and they lack sufficient wealth, the legal system can do little

to ensure debt repayment.

Our results indicate that individual reputation formation in long-term credit relations

has a powerful impact on the enforcement of credit contracts. In the absence of third party

enforcement, the lack of reputation formation opportunities leads to a breakdown in credit

market trading. If borrowers can acquire a reputation, however, stable credit markets emerge

in which roughly 80% of all feasible trades take place. If borrowers’ identities are known the

lenders condition future credit offers on the borrower’s current repayment behavior such that

the borrowers face incentives to repay their debt and to choose the efficient low-risk project.

Thus, reputation formation in endogenously formed long-term credit relations strongly

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alleviates the double moral hazard problem in our credit market although it does not solve it

completely.

The introduction of third party enforcement into a market in which reputation

formation plays a key role in contract enforcement leads to a further significant increase in

trading activity. Interestingly, third party enforcement does not reduce the prevalence of

multi-period credit interactions between pairs of borrowers and lenders. However, the

efficiency gains from third party enforcement are surprisingly small and insignificant because

it exacerbates the project choice problem. In fact, without third party enforcement the efficient

project is chosen in 90% of the cases while in the presence of third party enforcement this

occurs only in roughly 50% of the cases.

The likely reason for the decrease in efficient projects is twofold. First, in the presence

of legal enforcement of repayments, borrowers face stronger short-term incentives to choose

the inefficient project. Due to limited liability and wealth constraints borrowers who are

forced to repay in case of project success can increase their expected short-term-profit by

choosing the risky project because the increased risk is partly borne by the lender. This effect

is especially strong because legal enforcement of debt repayment also strengthens the lenders’

position in the market and induces them to ask for higher repayments. Second, we find that

the conditioning of future credit on current repayment is weaker under third party

enforcement, i.e., incumbent borrowers who repay their credit experience a lower increase in

the probability of receiving future credit. Together these two factors imply that third party

enforcement weakens the incentives for efficient project choices in important ways which

leads to a lower prevalence of efficient projects.

Our study is related to the literature on relationship banking that examines the

economic role and the determinants of long-term relations between borrowers and lenders

(Petersen and Rajan 1994, Berger and Udell 1995, Boot 2000, Boot and Thakor 2000, Ongena

and Smith 2000 and 2001, Degryse and Ongena 2005). This literature provides convincing

evidence for the prevalence and the potentially value-enhancing role of long-term

relationships in credit markets. In principle, long-term relations could be valuable because the

lender has access to the borrower’s books and thus receives more direct insights into the

borrower’s economic activities which enable her to better assess the risks involved in

providing credit. Alternatively, long-term relations may be a consequence of lenders’

contingent renewal of future credit contracts: if lenders condition access to future credit on the

repayment of current debt the borrowers face incentives to repay their debt. Thus, here the

existence of long-term credit relations merely results from the successful repayment of credit

which is itself a result of the incentives provided by contingent contract renewal.

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It is hard, if not impossible, to disentangle these forces in existing field data while our

experiment enables us to isolate them in a clean way. In particular, in the experiments the

lender never had access to information about the borrower’s past or current project choices.

Therefore, we can rule out that long-term relations are associated with better information

access. Instead, long-term relations are a result of lenders’ contingent renewal policy, the

associated incentives for credit repayment and efficient project choices and, therefore, they

enhance the gains from trade in our credit markets.

Our study is also related to the literature on the role of legal enforcement institutions

in credit markets (e.g., La Porta and Lopez de-Silanes 1997, La Porta et al. 1998, Djankov,

McLiesh and Shleifer 2007). This literature documents that the role of private credit in a

market economy increases with creditor protection, indicating an important role of legal

enforcement institutions. The interpretation of correlational data is however not easy because

causation can go in both directions. Creditor protection may cause flourishing credit markets

but it is also possible that credit markets emerge through endogenous (reputational)

enforcement mechanisms and that higher credit market participation causes political pressures

that strengthen creditors’ rights. In view of the uncertainty whether reverse causation is partly

behind the observed link between creditor protection and the economic role of private credit

in cross country comparisons, an experimental study of the role of legal enforcement of credit

repayment is valuable because in the experiment we can rule out reverse causation with

certainty. Thus, we can be completely sure that the increased level of trading activity under

legal enforcement is caused by the enforcement institution.

In addition, the exogenous introduction of legal enforcement in an environment with

endogenous enforcement of credit contracts enables us to study the causal impact of legal on

endogenous enforcement. To the best of our knowledge we are the first ones who empirically

address the important question of how endogenous (reputation based) incentives interact with

exogenous (legal) incentives. Our finding that legal enforcement weakens reputational

incentives and increases the frequency of inefficient project choices indicates that legal and

endogenous enforcement mechanisms may have unexpected interactions which renders the
further study of such interaction effects worthwhile.5

Since we investigate the disciplining power of relationships our work is also related to

the literature on reputation formation in repeated games (Kreps et al. 1982, Sobel 1985,

5 Baker, Gibbons and Murphy (1994) provide a theoretical analysis between explicit incentives and relational
incentives in a firm–worker relationship. They show that better explicit incentives may weaken relational
incentives because a better explicit incentive reduces the firm’s ability to commit to bonus payments that
incentivize the workers’ effort. In our setting, the crowding out of relational incentives through legal
enforcement of debt repayment is based on a different mechanism – the lender’s weaker conditioning of future
credit on current repayment. An examination of the interaction between informal and formal enforcement in
partnerships is provided by Sobel (2006).

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Fudenberg and Maskin 1986). This literature shows that cooperation can be sustained as an

equilibrium in situations involving repeated play. However, the theory also reveals (e.g.

Fudenberg and Maskin 1986) that there is in general a plethora of equilibria some of which

involve full cooperation while others involve complete defection by all players. For this

reason, theory alone provides little guidance regarding the likely consequences of reputation

formation for the functioning of credit markets. Recent experimental work provides evidence

that reputation formation can indeed mitigate moral hazard problems. For example, Brown et

al. (2004) find that individual reputation effects have efficiency enhancing effects in

endogenously formed employment relationships and Brown and Zehnder (2007) show that

information sharing among lenders provides strong incentive for borrowers to repay their

debt. However, our experiment differs from these experiments in important aspects. First, the

former experiments make reputation formation easy because they use deterministic setups in

which the principal can directly observe the agent’s action whereas our set-up captures a key

characteristic of credit markets – asymmetric information between borrowers and lenders and

uncertainty about project success. For this reason, previous experiments also cannot study the

simultaneous occurrence and interaction of the two key moral hazard problems in credit

markets – the repayment problem and the project choice problem. Second, previous

experimental studies also do not examine the interaction between legal enforcement and

relation incentives.

In the presence of stochastic project success and asymmetric information it is far from

obvious that repeated interactions are capable of sustaining cooperation between borrowers

and lenders. The reason is that the lenders cannot observe the borrower’s project choice nor

can they observe whether the project has been successful; they can only observe whether the

borrower repays his credit. If a borrower does not repay his credit in the market without legal

enforcement the lender does not know whether the borrower is unable to repay his credit

(because the project failed) or unwilling to repay his debt. Even an honest borrower who

intends to repay his debt in case of project success and who chooses the efficient low risk

project may face a project failure so that he cannot repay his debt. The lender never has

certainty about whether he faced an opportunistic borrower who did not intend to repay his

debt even in case of project success or whether the borrower had just bad luck. The double

moral hazard problem in our credit market makes it thus very difficult to acquire a reputation

as a good borrower, which makes the powerful effect of individual reputation formation

opportunities on contract enforcement all the more remarkable.

The remainder of the paper is structured as follows: in Section II we present the details

of our experimental design and the applied procedures. Section III contains our predictions

and hypotheses. In Section IV we present our results and Section V concludes the paper.

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