Reputation and Credit Market Formation

In this paper we show that reputation formation in endogenously formed relationships is a decisive determinant for the existence and performance of credit markets. In theabsence of any third party enforcement of debt repayment the contracting parties succeed in establishing stable bilateral relations in which the borrowers repay out of reputationalconcerns. As a consequence mutually beneficial trades can take place. The introduction of third party enforcement of debt repayment generates surprisingly small effciency gains.This is due to the fact that third party enforcement of debt repayment not only solves the moral hazard problem associated with debt repayment but also exacerbates the moral hazard problem that is associated with project choices. Whereas in the absence of third party enforcement of debt repayment most borrowers choose the effcient project, theintroduction of third party enforcement causes an increase in the number of ineffcient projects. But also in this environment the market participants realize a large fraction of the available gains from trade by forming bilateral relations in which a reputation mechanism forces borrowers to choose the effcient project very frequently.