If the second period re nanced project fails the bank

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Unformatted text preview: ceiving nothing in this event. Otherwise it can refinance the loan for one more period, injecting an additional unit of money into the operation. In this event, with probability p it generates Rp for the bank and with probability (1 − p) it fails, generating a liquidation value Lp < L. The entrepreneur receives private benefits of Bp in both cases. If the second period re-financed project fails, the bank collapses if not bailed-out as we assume its net position is then negative (more on this below). To keep matters simple, we assign all the bargaining power to the bank so that the bank is able to extract all the monetary returns from financing the projects and entrepreneurs are limited to private benefits. In order to formalize the idea of bank moral hazard, that is, the idea that banks may be passive in their lending practices with the expectation that the government will bail them out if their projects turn out poorly, we graft a game between the government and the bank on top of this game between the bank and the entrepreneur. Suppose the government can decide to monitor the bank to ascertain whether the bank liquidates bad projects or remains passive. 4 The government does this by choosing ex-ante, in the first period, on a detection probability γ that involves a cost c(γ ), c > 0, c > 0. Detection takes place after the refinancing stage, and if detected the management of the bank is fired and the bank is recapitalized (bailed-out) to the extent of its negative net position. In other words, by the time bank passivity has been detected by the government, the damage has already been done; it is too late to undo the banks refinancing decision. The timing of the game is as follows. In period 1 the government decides on γ and incurs the monitoring cost c(γ ). The bank lends to finance projects, and entrepreneurs with poor projects decide on their effort level. In period 2, returns are observed and the bank decides whether to liquidate or not, by choosing a level of activity a ∈ [0, 1]. Immediately afterward the government monitors and fires passive bank managers, in which case they get nothing, and recapitalizes the bank if it has a negative net position. The timing and structure of the game is depicted in Figure 1. [Insert Figure 1 here] There are thus two layers of soft-budget constraint problems in this environment, one at the level of the government-bank interaction and the other at the level of the bank-firm interaction. As we will see, a soft-budget constraint at the first level can be transmitted to the next level. We analyze the model by applying standard backward induction techniques. We start by asking what will be the effort choice of the entrepreneur with the bad project. In period 2, if the bank re-finances the project, the entrepreneur receives Bp . This happens with probability (1 − a). Thus the entrepreneur shirks if (1 − a)Bp ≥ Bg . In other words, firms have hard budget constraints only if the bank is sufficiently active; t...
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