Implicit Benefits and Financing

Abstract

Family, social and business connections create implicit benefits between borrowers and lenders. We model how these benefits influence credit allocation, cost, and renegotiation between the borrower and the lender in case of delinquency. The optimal solution illustrates that financing with implicit benefits achieves lower financing costs, higher managerial effort, and better economic outcomes for both the borrower and the lender in a competitive market or in a monopoly market where the lender maximises profit. The results reconcile the empirical evidence that financing through family, social and business networks is prevalent and often associated with good economic results even though it can be destructive in some scenarios. The model also demonstrates that, since a non-contractual, non-legal-based environment can trigger ex-post non-pecuniary costs on the borrower and lender, only politically connected (or other powerful) players survive when these costs are large. Finally, informational and financial disadvantage due to the growing size and complexity of projects, and the breakdown of relationships in modern society may explain the decline of financing in social networks despite the advantages arising from implicit benefits.