Competition, Risk Neutrality and Loan Commitments

Arnoud Boot, Anjan Thakor () and Gregory Udell ()

Finance from University Library of Munich, Germany

Abstract: We rationalize fixed rate loan commitments (forward credit contracting with options) in a competitive credit market with universal risk neutraility. Future interest rates are random, but there are no transactions costs. Borrowers finance projects with bank loans and choose ex post unobseravable actions that affect project payoffs. Credit contract design by the bank is the outcome of a (non-cooperative) Nash game between the bank and the borrower. The initial formal analysis is basically in two steps. First, we show that the only spot credit market Nash equilibria that exist are inefficient in the sense that they result in welfare losses for borrowers due to the bank's informational handicap. Second, we show that loan commitments, because of their ability to weaken the link between the offering bank's expected profit and the loan interest rate, enable to the complete elimination of informationally induced welfare losses and thus produce an outcome that strictly Pareto dominates any spot market equilibrium. Perhaps our most surprising result is that, if the borrower has some initial liquidity, it is better for the borrower to use it now to pay a commitment fee and buy a loan commitment that entitles it to borrow in the future rather than save it for use as an inside equity in conjunction with spot borrowing.

JEL-codes: G (search for similar items in EconPapers)
Pages: 23 pages
Date: 2004-11-30
New Economics Papers: this item is included in nep-fin
Note: Type of Document - pdf; pages: 23
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (6)

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Related works:
Journal Article: Competition, risk neutrality and loan commitments (1987)
Working Paper: Competition, risk neutrality and loan commitments (1987)
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Persistent link: https://EconPapers.repec.org/RePEc:wpa:wuwpfi:0411051

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