Supersedes Working Paper 16-01 - Financial Contracting with Enforcement Externalities

The authors propose a unifying theory that models the interplay between enforcement, borrower default decisions, and the provision of credit. The central tenets of their framework are the presence of capacity constrained enforcement and borrower heterogeneity. The authors show that, despite heterogeneity, borrowers tend to coordinate their default choices, leading to fragility and to credit rationing. Their model provides a rationale for the comovement of enforcement, default rates and credit seen in the data.