A Model of Dynamic Liquidity Contracts

The main goal of this paper is to analyze the nature of long-term liquidity contracts that arise between lenders and borrowers in the absence of perfect enforceability and when both parties are financially constrained. We study an infinite horizon dynamic contracting model between a borrower and a lender with the following features: The borrower, is credit-constrained, faces a stochastic project arrival process every period, can choose to renege each period, and can save through the lender. Projects are indivisible. The lender is resource- constrained, and can commit to the terms of the contract as long as it is ex-ante individually rational to do so. We show that: (i) Enforcement problems and endogenous resource constraints can severely curtail the possibility of financing projects, (ii) the economy exhibits investment cycles, (iii) credit is rationed if either the lender has too little capital or the borrower has too little financial collateral. This paper’s technical contribution is to show the existence and characterization of financial contracts that are solutions to a non- convex dynamic programming problem.