The Role of Dynamic Renegotiation and Asymmetric Information in Financial Contracting

In the paper, The Role of Dynamic Renegotiation and Asymmetric Information in Financial Contracting, which was recently made publicly available on SSRN, I show that frequent renegotiation is an integral part of bank lending. Its role is as a complement to restrictive lending agreements that place significant constraints on borrowers’ behaviors. Indeed, it is precisely because borrowers are able to renegotiate the terms of their contracts that they are willing to accept such restrictive contracts in the first place. Thus, the ex post renegotiations have several important implications for our understanding of bank lending.

In particular, renegotiation influences the design of the initial contract. It influences the terms of the agreement once the relationship is underway. It influences the behavior of the contracting parties throughout the relationship. It also influences the information environment by slowing the revelation of information.

On a more practical level, the study also provides a cautionary note for researchers investigating loan contracts. When ex post renegotiation is possible – virtually inevitable – the role of the initial terms of the contract is less permanent and different. Contracts are necessarily structured with future bargaining in mind. Further, many of the observations in the popular Dealscan database are simply renegotiations of the same credit agreement. In light of the differences between origination and renegotiation, this distinction is important for studies attempting to understand the contracting process between lenders and borrowers.

The full paper is available for download here.