A relational theory of relationship lending under contractual incompleteness

While the literature has focused on relationships as a technology for solving hidden information problems in credit markets, hidden action has been very little explored as an explanation for the existence of relational lending. In this paper, we propose a theory in which relationships are driven by the problem of contractual incompleteness in instances in which a borrower, by taking ex-ante actions, magnifies the hazards related to ex-post bargaining over returns. A relationship commits the borrower to take actions that minimize the ex-post conflict of interests resulting from contractual incompleteness. We show that a robust feature of an optimally designed lending relationship (i.e., the best Public Perfect Pure Strategy Equilibrium in a repeated lending game) is that a sufficiently patient entrepreneur, upon choosing his actions, ignores his privately observed contingencies. This commitment solves the credit rationing problem that arises in a one-shot (arm’s length) interaction, and reduces, when compared to arm’s length financing, the interest rate that a bank charges for a credit line. Although in a less acute fashion, we also show that the same features just described appear in an optimal lending relationship for the case in which the entrepreneur is impatient.