Complementarity and Financial Systems - A Theoretical Approach

Individual financial systems can be understood as very specific configurations of certain keyelements. Often these configurations remain unchanged for decades. We hypothesize that thereis a specific relationship between key elements, namely that of complementarity. Thus,complementarity seems to be an essential feature of financial systems.Intuitively speaking, complementarity exists if the elements of a (financial) system reinforceeach other in terms of contributing to the functioning of the system. It is the purpose of thispaper to provide an analytical clarification of the concept of complementarity. This is done bymodeling financial systems as combinations of four elements: firm-specific human capital of anentrepreneur, the ability of a bank to restructure the borrower's firm in the case of distress, thepossibility to appropriate private benefits from running the firm, and the bankruptcy law. Aspecific configuration of these elements constitutes one financial system.The bankruptcy law and the potential private benefits are treated as exogenous. Theydetermine the bargaining power of the contracting parties in the case that recontracting occurs.In a two-stage game, the optimal values for the other elements are determined by the agentsindividually - by investing in human capital and restructuring skills, respectively - and jointly bywriting, executing and possibly renegotiating a financing contract for the firm. The paperdiscusses the equilibria for different types of bankruptcy law and demonstrates that equilibriaexhibit the sought-after feature of complementarity. Three particularly significant equilibriacorrespond to stylized accounts of the British, German and the US-American financial system,respectively.