Reputation and Credit Market Formation:How Relational Incentives and LegalContract Enforcement Interact

The evidence suggests that relational contracting and legal rules play an important role incredit markets but on the basis of the prevailing field data it is difficult to pin down their causalimpact. Here we show experimentally that relational incentives are a powerful causaldeterminant for the existence and performance of credit markets. In fact, in the absence oflegal enforcement and reputation formation opportunities the credit market breaks downalmost completely while if reputation formation is possible a stable credit market emergeseven in the absence of legal enforcement of debt repayment. Introducing legal enforcementof repayments causes a further significant increase in credit market trading but has only asurprisingly small impact on overall efficiency. The reason is that legal enforcement of debtrepayments weakens relational incentives and exacerbates another moral hazard problem incredit markets – the choice of inefficient high-risk projects....