Regulating Exclusion from Financial Markets∗

We study optimal enforcement in credit markets in which the only threat facing a defaulting borrower is restricted access to financial markets. We solve for the optimal level of exclusion, and link it to observed institutional arrangements. Regulation in this environment must accomplish two objectives. First, it must prevent borrowers from defaulting on one bank and transferring their resources to another bank. Second, and less obviously, it must give banks the incentive to make sizeable loans, and to honor their promises of future credit. We establish that the optimal regulation resembles observed laws governing default on debt. Moreover, if debtors have the right to a “fresh start” after bankruptcy then this must be balanced by enforceable provisions against fraudulent conveyance. Our optimal regulation is robust, in that it can be implemented in a way that does not require the regulator to have information about either the borrower or lender. Finally, restricting the availability of credit to a defaulted borrower is not a threat, in and of itself, that motivates borrowers to repay loans. ∗We thank Viral Acharya, Kaushik Basu, Mike Fishman, Denis Gromb, Adriano Rampini and members of seminar audiences at the International Monetary Fund, London Business School, Northwestern University, Princeton University, Stanford University, the NBER Summer Meetings and the NEUDC conference for helpful comments. We are particularly grateful to the editor and two anonymous referees for helpful comments based on careful readings of a substantially longer version of this paper. Bond thanks the Institute for Advanced Study for hospitality and financial support over the academic year 2002-03. Any remaining errors are of course our own. †Northwestern University. E-mail:[email protected]. ‡Northwestern University. E-mail:[email protected].