Reputation and Credit Market Formation: How Relational Incentives and Legal Contract Enforcement Interact

This paper examines how reputation formation opportunities causally influence contract enforcement and market efficiency in credit markets. It also studies the causal impact of legal third party enforcement of credit contracts and the interaction between legal enforcement and the endogenous enforcement of contracts in long-term credit relations. The study involved experiments in a laboratory environment in which two potential sources of moral hazard coexist. These include the presence of asymmetric information about project characteristics and the absence of legal enforcement of debt repayment. The study shows that relational incentives are a powerful causal determinant for the existence and performance of credit markets. Findings include:

• In the absence of legal enforcement and reputation formation opportunities, the credit market breaks down almost completely;
• If reputation formation is possible, a stable credit market emerges even in the absence of legal enforcement of debt repayment;
• Introducing legal enforcement of repayments causes a significant increase in credit market trading, but has little impact on overall efficiency;
• Legal enforcement of debt repayments weakens relational incentives and exacerbates moral hazard problems.