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A model of credit risk without commitment

Leonardo Martinez and Juan Hatchondo

No 940, 2008 Meeting Papers from Society for Economic Dynamics

Abstract: This paper studies an economy with credit risk in which borrowers cannot commit to exclusive contracts with lenders as in Bizer and DeMarzo (1992). But we study a framework with multiple borrowing periods. In particular, we remove the exclusive contracts assumption from a baseline model of credit risk `a la Eaton and Gersovitz (1981), similar to those used in quantitative studies of household bankruptcy, corporate bankruptcy and sovereign default. We compare equilibrium allocations with and without commitment to exclusive contracts. We show that borrowing levels may be lower without commitment. This is the case because when commitment to exclusive contracts is not assumed, an increase in current borrowing levels deteriorates future borrowing conditions. This does not occur when commitment is assumed. This finding stands in sharp contrast with the results in previous work that study environment where current borrowing does not affect future borrowing opportunities. We also show that borrowing levels tend to be lower without commitment if the borrowers’ discount factor is higher or debt needs to be rollover more often, and when the endogenous default probability is lower.

Date: 2008
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