DP17264 Implicit Benefits and Financing

Author(s): Franklin Allen, Meijun Qian, Jing Xie
Publication Date: April 2022
Keyword(s): banks, corporate insider debt, Debt Financing, Implicit benefits, joint equity-debt ownership, social and business networks
JEL(s): D02, G21, G23
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=17264

Social relationship and business connections create implicit benefits between borrowers and lenders. We model how implicit benefits and repayment enforcement costs influence credit allocation, cost, and renegotiation. The optimal solution illustrates that financing with implicit benefits can in many circumstances achieve lower financing costs, higher managerial effort, and better economic outcomes for both the borrower and the lender. This result explains the continuing expansion of alternative financing despite advanced formal financial intermediation, the rise of corporate insider debt, and joint ownership of debt and equity. The growing size and complexity of projects and changes in community relationships explain the expansion of bank financing.