The 2008 crash has left all the established economic doctrines - equilibrium models, real business cycles, disequilibria models - in disarray. Part of the problem is due to Smith’s "veil of ignorance": individuals unknowingly pursue society’s interest and, as a result, have no clue as to the macroeconomic effects of their actions: witness the Keynes and Leontief multipliers, the concept of value added, fiat money, Engel’s law and technical progress, to name but a few of the macrofoundations of microeconomics. A good viewpoint to take bearings anew lies in comparing the post-Great Depression institutions with those emerging from Thatcher and Reagan’s economic policies: deregulation, exogenous vs. endoge- nous money, shadow banking vs. Volcker’s Rule. Very simply, the banks, whose lending determined deposits after Roosevelt, and were a public service became private enterprises whose deposits determine lending. These underlay the great moderation preceding 2006, and the subsequent crash.

The Economic Institutions of Capitalism

This article examines the economics of financing small business in private equity and debt markets. Firms are viewed through a financial growth cycle paradigm in which different capital structures are optimal at different points in the cycle. We show the sources of small business finance, and how capital structure varies with firm size and age. The interconnectedness of small firm finance is discussed along with the impact of the macroeconomic environment. We also analyze a number of research and policy issues, review the literature, and suggest topics for future research.

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The economics of small business finance: The roles of private equity and debt markets in the financial growth cycle

This article examines the role of relationship lending in small firm finance. It examines price and nonprice terms of bank lines of credit extended to small firms. The focus on bank lines of credit allows the examination of a type of loan contract in which the bank-borrower relationship is likely to be an important mechanism for solving the asymmetric information problems associated with financing small enterprises. The authors find that borrowers with longer banking relationships pay lower interest rates and are less likely to pledge collateral. These results are consistent with theoretical arguments that relationship lending generates valuable information about borrower quality. Copyright 1995 by University of Chicago Press.

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Relationship Lending and Lines of Credit in Small Firm Finance

Relationship Banking: What Do We Know?

Customer relationships arise between banks and firms because, in the process of lending, a bank learns more than others about its own customers. This information asymmetry allows lenders to capture some of the rents generated by their older customers; competition thus drives banks to lend to new firms at interest rates which initially generate expected losses. As a result, the allocation of capital is shifted toward lower quality and inexperienced firms. This inefficiency is eliminated if complete contingent contracts are written or, when this is costly, if banks can make nonbinding commitments that, in equilibrium, are backed by reputation. THIS PAPER DERIVES A dynamic theory of "customer relationships" in bank loan markets. The theory builds on a traditional view of bank lending behavior, first spelled out by Hodgman (1961) and Kane and Malkiel (1965) and later elaborated upon by Wood (1975). According to this view, an essential factor underlying a bank's loan pricing policy is its impact on the bank's stock of loyal customers, as well as on those customers' deposits. Rather than take relationships as a given, we examine the implications of the view expressed, for example, by Fama (1985), that they arise because of "inside information" generated by the history of bankfirm interactions. In our theory, customer relationships arise endogenously as a consequence of the asymmetric evolution of information sets. In contrast with most theories of pricing under asymmetric information, though, the key informational asymmetry postulated here is that which arises between agents on the same side of the market. We exploit the presumption, made by Kane and Malkiel (1965) and Fama (1985), that a bank which actually lends to a firm learns more about that borrower's characteristics than do other banks. A fundamental consequence of this asymmetric evolution of information is the potential creation of ex post, or temporary, monopoly power. If it is relatively costly for banks and firms to write multiperiod contingent contracts, this ex post monopoly power has undesirable effects on the allocation of capital. Even though banks earn zero expected profit over the lifespan of the average customer relationship, they are not disciplined by the market to offer

Asymmetric Information, Bank Lending, and Implicit Contracts: A Stylized Model of Customer Relationships

How will banks evolve as competition increases from other banks and from the capital market? Will banks become more like capital market underwriters and offer passive transaction loans or return to their roots as relationship lending experts? These are the questions we address. Our key result is that as interbank competition increases, banks make more relationship loans, but each has lower added value for borrowers. Capital market competition reduces relationship lending ~and bank lending shrinks!, but each relationship loan has greater added value for borrowers. In both cases, welfare increases for some borrowers but not necessarily for all. RAPID CHANGES IN F INANCIAL SERVICES ARE threatening commercial banks. In the United States, mutual funds such as Fidelity and Merrill Lynch compete for banks’ core deposits. Investment banks, armed with a variety of financial market innovations, challenge banks’ traditional lending products. Banks also find themselves in greater competition with one another as globalization and deregulation weaken geographic boundaries and encourage crossborder ~Europe! and interstate ~U.S.! banking. These developments raise numerous fundamental questions. Will the relationship-oriented European bank system survive competitive pressures in this changing environment? Will U.S. banks focus more on “relationship banking” 1 —whereby banks invest in building relationships with borrowers—or on “transaction banking,” which involves “arm’s length” transactions rather

https://www.jstor.org/stable/pdfplus/222519.pdf

Can Relationship Banking Survive Competition

We analyze repeated moral hazard with discounting in a competitive credit market with risk neutrality. Even without learning or risk aversion, long-term bank-borrower relationships are welfare enhancing. The main result is that the borrower obtains an infinite sequence of unsecured loans at below spot market cost following the first good project realization. This contract produces first-best action choices. Prior to this stage, the borrower gets secured loans with above-market borrowing cost. The optimal contract thus displays a "selective memory" feature, taking only one of two forms at any given point in time, depending on prior history. We consider an infinitely repeated bank-borrower relationship with moral hazard and universal risk neutrality, and explore the ramifications of credit contract duration when the two well-known benefits of long-term contracting-learning and improved risk sharing-are absent. Our objectives are twofold. The first is to analyze an infinitely repeated game with discounting in a credit market context. We thus relate the theory of repeated games to financial intermediation theory, particularly to issues of moral hazard and collateral-related distortions. The second objective is to understand noteworthy stylized facts of credit markets, such as durability in credit relationships, lower borrowing costs for established borrowers, and unsecured loans for established borrowers versus secured loans for newer borrowers. While these practices may be partly due to learning, we show that learning is not essential to rationalize them. Even if information decays rapidly and banks learn nothing about borrowers through time, these aspects of credit contracting arise in a repeated-game context. Our main results are as follows. First, despite universal risk neutrality and the absence of learning, a durable bank relationship benefits the borrower.2 The intuition is that the long-term contracting permitted by a durable relationship enables the bank to efficiently tax and subsidize the borrower through time to reduce the use of (costly) collateral. Second, the average welfare loss (due to moral hazard) per period is positive even as the time horizon goes to infinity. Third, the optimal infinite-horizon contract has the striking property that, following the period

Moral hazard and secured lending in an infinitely repeated credit market game

This article builds a theory of financial system architecture. We ask: what is a financial market, what is a bank, and what determines the economic role of each? Starting with basic assumptions about primitives--the types of agents and the nature of the informational asymmetries--we provide a theory that explains which agents coalesce to form banks and which trade in the capital market. It is shown that borrowers of higher observable qualities access the financial market. Moreover, a financial system in its infancy will be bank-dominated, and increased financial market sophistication diminishes bank lending. Article published by Oxford University Press on behalf of the Society for Financial Studies in its journal, The Review of Financial Studies.

https://bauer.uh.edu/nlangberg/papers_shiva/boot thakor 1997 rfs.pdf

Financial System Architecture

The authors examine collateral in a competitive equilibrium in which borrowers can choose hidden actions and may additionally possess hidden knowledge. Apart from explaining the widespread use of collateral despite deadweight costs, they show that an increase in the riskless interest rate causes equilibrium loan rates and collateral requirements to increase, a decline in the deadweight costs of collateral reduces the equilibrium collateral use under moral hazard, and an increase in the borrower's project size reduces equilibrium collateral use under moral hazard. Some of these predictions are tested and found to be supported by the data. Copyright 1991 by Royal Economic Society.

Arnoud W. A. Boot

Papers

Relationship Banking: What Do We Know?

Can Relationship Banking Survive Competition

Moral hazard and secured lending in an infinitely repeated credit market game

Financial System Architecture

Secured Lending and Default Risk: Equilibrium Analysis, Policy Implications and Empirical Results