Presidential Address, Committing to Commit: Short‐term Debt When Enforcement Is Costly

  • Author(s): Douglas W. Diamond
  • Published: Nov 27, 2005
  • Pages: 1447-1479
  • DOI: 10.1111/j.1540-6261.2004.00669.x

ABSTRACT

In legal systems with expensive or ineffective contract enforcement, it is difficult to induce lenders to enforce debt contracts. If lenders do not enforce, borrowers will have incentives to misbehave. Lenders have incentives to enforce given bad news when debt is short‐term and subject to runs caused by externalities across lenders. Lenders will not undo these externalities by negotiation. The required number of lenders increases with enforcement costs. A very high enforcement cost can exceed the ex ante incentive benefit of enforcement. Removing lenders' right to immediately enforce their debt with a “bail‐in” can improve the ex ante incentives of borrowers.

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