Reciprocity and Reputation on Credit Market: Experimental Evidence

This paper reports the results of an experiment that investigates the effects of reciprocity and reputation on credit market performance. To do so, we replicate the three treatments carried out by Fehr and Zehnder (2005) in their experiment and introduce some alterations. More precisely, in our experiment, participants are matched by pairs exogenously so they have the opportunity of reputation building. Furthermore, our experiment allows us to investigate the effect of information on reputation building. In the first treatment called partner no information a lender and a borrower are matched for the all duration of the experiment. The second treatment (stranger no information) is identical to the previous one except that it is played under a stranger matching protocol. The third treatment (partner information) solely differs from the first one by the fact that the lenders have access to the project selected by the borrowers and the project outcome. The last treatment (Third party no information) allows for the introduction of a third party in charge of enforcing the contracts whereas in the three conditions aforementioned the contracts are not enforceable by an exogenous force. Our results show that an honour-based market – wherein participants cannot build up long term relationship – is not viable on the long run because borrowers have no repayment incentives, though a significant fraction of borrowers reciprocate fair offers. The opportunity to engage bilateral long term relationships strongly improves the market performance by partially mitigating the repayment problem and thus enhancing cooperation between borrowers and lenders. The latter succeed in applying a conditional contract renewal strategy. As a consequence selfish borrowers have an incentive to behave reciprocally. Surprisingly, rendering the information symmetric and transparent between the two parties involved does not improve market performance. This fact seems to highlight the prominence of reputation as a disciplining devise. The presence of an exogenous force in charge of enforcing contract undeniably improves the credit market functioning by solving the repayment problem and thus giving more confidence to the investors but also exacerbates moral hazard associated with project selection. Interestingly, the fact that lenders offer fair financing conditions significantly lowers moral hazard