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Presidential Address, Committing to Commit: Short-term Debt When Enforcement Is Costly

Authors

  • Douglas W. Diamond

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    • Douglas W. Diamond is at the University of Chicago, GSB and NBER. I am grateful to Douglas Baird, Tom Knox, Jeff Lacker, Robert Merton, Toby Moskowitz, Haresh Sapra, Elu von Thadden, Zvi Weiner, Luigi Zingales, and especially Effi Benmelech and Elizabeth Cammack for many helpful comments. This paper builds on joint work with Phil Dybvig and Raghu Rajan. I thank the National Science Foundation and the Center for Research in Security Prices at the University of Chicago for financial support.


ABSTRACT

In legal systems with expensive or ineffective contract enforcement, it is difficult to induce lenders to enforce debt contracts. If lenders do not enforce, borrowers will have incentives to misbehave. Lenders have incentives to enforce given bad news when debt is short-term and subject to runs caused by externalities across lenders. Lenders will not undo these externalities by negotiation. The required number of lenders increases with enforcement costs. A very high enforcement cost can exceed the ex ante incentive benefit of enforcement. Removing lenders' right to immediately enforce their debt with a “bail-in” can improve the ex ante incentives of borrowers.

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