Journal Article

Regulating Exclusion from Financial Markets

Philip Bond and Arvind Krishnamurthy

in The Review of Economic Studies

Published on behalf of Review of Economic Studies Ltd

Volume 71, issue 3, pages 681-707
Published in print July 2004 | ISSN: 0034-6527
Published online July 2004 | e-ISSN: 1467-937X | DOI:
Regulating Exclusion from Financial Markets

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  • Financial Regulation
  • Banking
  • Economic Development


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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 honour 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. Our results isolate the way in which specific institutions surrounding bankruptcy—namely rules governing asset garnishment and fraudulent conveyances—support loan markets in which borrowers have no collateral.

Keywords: G21; G28; O16

Journal Article.  15794 words.  Illustrated.

Subjects: Financial Regulation ; Banking ; Economic Development

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