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Should Courts Enforce Credit Contracts Strictly?* 

Authors


  • * 

    A preliminary version of this paper was co-authored by Davide Iacovoni, whose contribution is gratefully acknowledged. The paper has greatly benefited from very helpful comments and suggestions by Antonio Ciccone, David de Meza, Alberto Niccoli and an anonymous referee of this Journal. Helpful discussions with Piero Alessandrini, Maria Rosaria Carillo, Pino Marotta, Luca Papi, Emma Sarno and Domenico Scalera are also gratefully acknowledged. All the opinions and mistakes are, of course, sole responsibility of the author. The research benefited from financial support from the Italian Ministry for Higher Education and Research (MIUR).

Abstract

The intimate linkages between law and finance are currently the centre of wide-ranging empirical investigations. This article presents a simple banking model with information asymmetries concerning borrowers’ entrepreneurial talent. It is shown that improvements in the enforcement of contract by courts reduce agency problems but can also reduce the bank's incentive to screen borrowers adequately, thus worsening credit allocation. A stricter enforcement of credit contracts, therefore, may be socially harmful even if costlessly achieved. Improvements in accounting standards, however, always make bank screening of borrowers less costly and improve credit allocation and social welfare.

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