Abstract - Discretionary Contracts, Competition and Bank-Firm Relationships

This paper provides a novel 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-à-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.

Anjolein Schmeits
Washington University in St. Louis
07.Jun 2005

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