Abstract
This paper studies reputation formation and the evolution over time of the incentive effects of reputation to mitigate conflicts of interest between borrowers and lenders. Borrowers use the proceeds of their loans to fund projects. In the absence of reputation effects, borrowers have incentives to select excessively risky projects. If there is sufficient adverse selection, reputation will not initially provide improved incentives to borrowers with short credit histories. Over time, if a good reputation is acquired, reputation will provide improved incentives. General characteristics of markets in which reputation takes time to work are identified.
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