Bargaining power and enforcement in credit markets

In a credit market with enforcement constraints, we study the effects of a change in the outside options of a potential defaulter on the terms of the credit contract, as well as on borrower payoffs. The results crucially depend on the allocation of “bargaining power” between the borrower and the lender. We prove that there is a crucial threshold of relative weights such that if the borrower has power that exceeds this threshold, her expected utility must go up whenever her outside options come down. But if the borrower has less power than this threshold, her expected payoff must come down with her outside options. In the former case a deterioration in outside options brought about, say, by better enforcement, must create a Lorenz improvement in state-contingent consumption. In particular, borrower consumption rises in all “bad” states in which loans are taken. In the latter case, in contrast, the borrower's consumption must decline, at least for all the bad states. These disparate findings within a single model permit us to interpret existing literature on credit markets in a unified way.