Monitored finance, usury and credit rationing

The paper analyzes the repeated interaction between a bank and a firm. A simple two period model is constructed, which explains several features of a credit relationship: It shows why bank finance is available for firms which cannot obtain bond financing, why credit contracts contain a .Material Adverse Clause. and why interest rates quoted by banks do not depend very much on risk. The model shows why, even if the interest rate is observed, other banks cannot take over the credit. This model is then used to give a new explanation for credit rationing. It is argued that banks may have to maintain a reputation for treating firms correctly. They will be reluctant to finance risky firms, because these credits will have to be renegotiated with a high probability which will endanger the bank’s reputation. Rationing of this type can arise either in stable economies with a lot of low risk firms or in a highly risky environment. Non profitmaximizing public banks may then be necessary in order to subsidize small or risky firms.