SSRN-id302936

# If they are passive then with probability p they are

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Unformatted text preview: hey have soft budget constraints otherwise. Firm behavior in turn aﬀects the ﬁnancial position of the bank. If ﬁrms have hard budget constraints, the banks net payoﬀ is Rg − 1. But if low quality ﬁrms do not exert eﬀort the bank’s net payoﬀ is a(θRg + (1 − θ)L − 1) + (1 − a)(1 − γ )p(θRg + (1 − θ)(Rp − 1) − 1) (1) In other words, if banks are active in liquidating poor quality projects their return is the ﬁrst term in the above expression. If they are passive, then with probability p they are 5 lucky, in which case their return is the second term above. If they are unlucky their return is θRg + (1 − θ)(Lp − 1) − 1 which can be negative if the proportion of high quality projects θ is small and the liquidation value Lp is not large either. We assume that this loss is bounded at zero because of limited liability but they collapse if not bailed out by the government. If we assume that the ﬁrst term within the brackets of the above expression, i.e., θRg + (1 − θ)L − 1 is positive, we do not have to worry about government bailout if the bank is active. Then the governments payoﬀ when ﬁrms have soft budget constraints can be written as −c(γ ) − (1 − a)(1 − p)(1 − θRg + (1 − θ)(1 − Lp )) (2) If we assume 1 − θRg + (1 − θ)(1 − Lp ) > 0, bailout is necessary if banks are passive. Note that the amount of bailout depends directly on a and not on γ , but a itself depends on γ. It is important that Lp − 1 < L so that government payoﬀ increases with bank activity. ¿From equation (1) we can see that the bank will prefer a = 1 if θRg + (1 − θ)L − 1 > (1 − γ )p(θRg + (1 − θ)(Rp − 1) − 1) which yields, γ>γ= (1 − θ)(p(Rp − 1) − L) − (1 − p)(θRg − 1) p(θRg + (1 − θ)(Rp − 1) − 1) (3) The bank’s decision is thus based on a comparison between the expected beneﬁts of being passive with the expectation of a bailout by the government and the potential loss if caught being passive. In the ﬁrst period, the government will choose the critical monitoring probability (γ ) that deters bank passivity if the cost of monitoring is less than the expected bail-out expenditure, c(γ ) ≤ (1 − p)(1 − θRg + (1 − θ)(1 − Lp )) The governments choice is thus binary. (4) If condition (4) is satisﬁed, it chooses γ and deters bank reﬁnancing of the project. Otherwise it accepts the soft budget constraint of ﬁrms and consequent bailout of banks ex-post. 6 2.1 Cronyism and Corporate Governance In order to understand the eﬀects of cronyism and changes in the corporate governance regime, now suppose that there are two groups into which we can subdivide ﬁrms: those that have crony ties with the bank and those that do not. Cronyism between banks and ﬁrms is often discussed as being manifested in the form of preferential ﬁnancing terms that banks oﬀer some, often low quality, ﬁrms. A simple way to incorporate this in the above framework is by assuming that when a low quality ﬁrm that has crony ties with the ba...
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## This document was uploaded on 02/28/2014 for the course ECONOMICS fn314 at Harvard.

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