Financial Contracting with Enforcement Externalities

Supersedes Working Paper 17-27 - Credit Enforcement Cycles and Working Paper 16-01 - Financial Contracting with Enforcement Externalities

The novel feature of our model is that enforcement capacity is accumulated ex ante and thus subject to depletion ex post. We characterize the effect of shocks that deplete enforcement resources on the aggregate default rate and credit supply. In the model default decisions by entrepreneurs are strategic complements, leading to multiple equilibria. We propose a global game selection to overcome equilibrium indeterminacy and show how shocks that deplete enforcement capacity can lead to a spike in the aggregate default rate and trigger credit rationing.