Regulating Exclusion from Financial Markets, Review of Economic Studies
We study optimal enforcement in credit markets in which the only threat facing a defaulting borrower is restricted access to financial markets. We solve for the optimal level of exclusion, and link it to observed institutional arrangements. Regulation in this environment must accomplish two objectives. First, it must prevent borrowers from defaulting on one bank and transferring their resources to another bank. Second, and less obviously, it must give banks the incentive to make sizeable loans, and to honor their promises of future credit. We establish that the optimal regulation resembles observed laws governing default on debt. Moreover, if debtors have the right to a
Philip Bond, Arvind Krishnamurthy
Bond, Philip, and Arvind Krishnamurthy. 2004. Regulating Exclusion from Financial Markets. Review of Economic Studies. 71(3): 681-707.