Optimal collective contract without peer information or peer monitoring

If entrepreneurs have private information about factors influencing the outcome of an investment, individual lending is inefficient. The literature typically offers solutions based on the assumption of full peer information to solve adverse selection problems and peer monitoring to solve moral hazard problems. In contrast, I show that it is possible to construct a simple budget-balanced mechanism that implements the efficient outcome even if each borrower knows only own type and effort, and has neither privileged knowledge about others nor monitoring ability. The mechanism satisfies participation incentives for all types, and is immune to the Rothschild–Stiglitz cream skimming problem despite using transfers from better types to worse types. The presence of some local information implies that the mechanism cannot be successfully used by formal lenders. Thus a local credit institution can emerge as an optimal response to the informational environment even without peer information or monitoring. Finally, I investigate the role of monitoring in this setting and show how costly monitoring can increase the scope of the mechanism

Optimal Collective Contract Without Peer Monitoring

If entrepreneurs have private information about factors influencing the outcome of an investment, individual lending is inefficient. The literature emphasizes improvements through non-market organizations that harness local information through peer monitoring. I investigate the complementary question of designing a credit mechanism when local information is limited, disabling peer monitoring. I show that a pooling mechanism that does not rely on peer monitoring can implement a market for rights-to-borrow, restoring efficiency. The mechanism achieves a strict Pareto improvement - providing incentive for each type of agent to join. Further, even though the mechanism involves pooling - and consequent implicit transfers from better types to worse types - it has a ``collective'' feature that makes it immune to the Rothschild-Stiglitz cream-skimming problem under competing contracts. Finally, the presence of even weak local information implies that the mechanism cannot be successfully used by formal lenders. Thus a local credit institution can emerge as an optimal response to the informational environment even without peer monitoring. I apply the results to contracts offered by rural moneylenders in developing countries.Informal Credit, Market for Rights-To-Borrow, Participation Incentives, Competition in Contracts and Cream Skimming, Local Information, Rural Moneylending

Credit booms and freezes

We show that short-term borrowing by intermediaries creates a rollover-coordination problem endogenously. We then introduce ambiguity and show that the coordination outcome is discontinuous in ambiguity attitude: starting from neutrality, any aversion implies a complete collapse for every value of fundamentals for which coordination matters, whereas any ambiguity loving causes successful coordination for all such values of fundamentals - a "lending euphoria." These help clarify credit booms even when backed by sub-prime assets as well as sudden credit freezes at the advent of bad news even for borrowers investing in non-sub-prime assets

Enforcing repayment: social sanctions versus individual incentives

Abstract We study repayment incentives generated through social sanctions and under pure in- dividual liability. In our model agents are heterogeneous, with differing degrees of risk aversion. We consider a simple setting in which agents might strategically default from a loan program. We remove the usual assumption of exogenous social penalties, and consider the endogenous penalty of exclusion from an underlying social cooperation game, modeled here as social risk-sharing. For some types of agents social risk-sharing can be sustained by the threat of exclusion from this arrangement. These types have social capital and can be given a loan that bootstraps on the risk-sharing game by using the threat of exclusion from social risk-sharing to deter strategic default. We show that the use of such sanctions can only cover a fraction of types participating in social risk sharing. Further, coverage is decreasing in loan duration. We then show that an individual loan programaugmented by a compulsory illiquid savings plan (such schemes are used by the Grameen Bank) can deliver greater coverage, and can even cover types excluded from social risk-sharing (i.e. types for whom social penalties are not available at all). Further, the coverage of an individual loan program has the desirable property of increasing with loan size as well as loan duration. Finally, we show that social cooperation enhances the performance of individual loans. Thus fostering social cooperation is beneficial under individual liability loans even though it has limited usefulness as a penalty under social enforcement of repayment. The results offer an explanation for the Grameen Bank’s adoption of individual liability replacing group liability in its loan programs since 2002

Too unexpected to fail: bail-out policy and sudden freezes

I present a mechanism that relies on the interaction of coordination and ambiguity (Knightian uncertainty) and makes precise how a loss of confidence can arise in loan markets, leading to a systemic liquidity crisis. The paper studies a simple global-game coordination model among lenders to a financial intermediary and shows how a market haircut arises in equilibrium. I show how the haircut responds to a variety of parameters. In particular, I show that coordination is non-robust to ambiguity in investor signals and becomes fragile in an environment with ambiguity. This leads to the haircut jumping up suddenly, possibly to 100% when enough lenders are ambiguity-sensitive. Further, I show that the fragility of coordination implies that in such an environment, policy itself becomes a systemic trigger. If the regulator fails to rescue an institution that the market expects to be saved, which in turn changes market expectation about policy for other institutions even slightly, an immediate systemic collapse of liquidity ensues. The results explain both the contagious run on liquidity markets at the advent of the recent crisis as well as the liquidity market freeze after the Lehman collapse. While what matters for the possibility run is whether an institution is too-unexpected-to-fail (TUTF), it is likely that institutions typically considered too-big-to-fail (TBTF) are also likely to be TUTF. The results then show that TBTF institutions limit the spread of crises, and breaking up a TBTF increases systemic vulnerability. Further, the results cast some doubt on the efficacy of the ring-fencing policy proposed by the UK banking commission

Ex Ante Versus Ex Post Regulation of Bank Capital

The current debate on the new Basel Accord gives rise to a natural question about the appropriate form of capital regulation.We construct a simple framework to analyze this issue. In our model the risk carried by a bank as well as managerial risk preference are a bank's private information. We show that ex ante constraints waste the superior risk information of a bank, while an ex post regime makes full use of it. However, the latter is more vulnerable to the problem of unknown managerial risk-aversion. The results imply that the two regimes are complements, rather than substitutes. Further, under plausible conditions, an ex post regime emerges as the dominant element of the optimal combination. We use the results to shed light on current policy concerns. In particular, our results provides theoretical underpinning for the inclusion of pillar 2 alongside pillar 1 in Basel II.Ex Ante Regulation, Ex Post Regulation, Asymmetric Information, Safety Loss, Overprotection Loss, Safety Bias, Basel II.

A Dynamic Mechanism and Surplus Extraction Under Ambiguity

In the standard independent private values (IPV)model, each bidder’s beliefs about the values of any other bidder is represented by a unique prior. In this paper we relax this assumption and study the question of auction design in an IPV setting characterized by ambiguity: bidders have an imprecise knowledge of the distribution of values of others, and are faced with a set of priors. We also assume that their preferences exhibit ambiguity aversion; in particular, they are represented by the epsilon-contamination model. We show that a simple variation of a discrete Dutch auction can extract almost all surplus. This contrasts with optimal auctions under IPV without ambiguity as well as with optimal static auctions with ambiguity - in all of these, types other than the lowest participating type obtain a positive surplus. An important point of departure is that the modified Dutch mechanism we consider is dynamic rather than static, establishing that under ambiguity aversion – even when the setting is IPV in all other respects – a dynamic mechanism can have additional bite over its static counterparts.Ambiguity Aversion; Epsilon Contamination; Modified Dutch Auction; Dynamic Mechanism; Surplus Extraction

Financial regulation under the coalition government

In this, the third article on Coalition Economics, Arup Daripa and Sandeep Kapur (Birkbeck, University of London) examine the changes to financial regulation made since 2010. They argue the Coalition has improved the overall regulatory architecture with respect to systemic risk, but made little progress on either the regulation of shadow banking activities or the introduction of methods of resolving (winding down) large banks that get into trouble. Daripa and Kapur’s earlier assessment of financial regulation under the Labour government, 1997-2010, is included in the special journal edition which is free to download until the election

Ex Ante versus Ex Post Regulation of Bank Capital

The current debate on the new Basel Accord gives rise to a natural question about the appropriate form of capital regulation. We construct a general framework to study this issue. We show that ex ante regulation wastes the expertise of a bank in measuring its risk exposure, while an ex post regime makes full use of it. However, the latter is more vulnerable to the problem of unknown managerial risk preference. The results imply that the two regimes are complements, rather than substitutes. Further, under plausible conditions, an ex post regime emerges as the dominant element of the optimal combination. We use the results to shed light on current policy concerns.Ex Ante Regulation, Ex Post Regulation, Asymmetric Information, Safety Loss, Overportection, Loss, Safety Bias, Basel II

Eliciting ambiguous beliefs under α-Maxmin preference

We study the problem of elicitation of subjective beliefs of an agent when the beliefs are ambiguous (the set of beliefs is a non-singleton set) and the agent’s preference exhibits ambiguity aversion; in particular, as represented by α-maxmin preferences. We construct a direct revelation mechanism such that truthful reporting of beliefs is the agent’s unique best response. The mechanism uses knowledge of the preference parameter α and we construct a mechanism that truthfully elicits α. Finally, using the two as ingredients, we construct a grand mechanism that elicits ambiguous beliefs and α concurrently