Soft Budget Constraints, Transition, and Financial Systems Author(s): Mathias Dewatripont and Grard Roland Reviewed work(s):

Source: Journal of Institutional and Theoretical Economics (JITE) / Zeitschrift fr die gesamte Staatswissenschaft, Vol. 156, No. 1, 17th International Seminar on the New Institutional Economics: Big-Bang Transformations of Economic Systems as a Challenge to New Institutional Economics (March 2000), pp. 245-260 Published by: Mohr Siebeck GmbH & Co. KG Stable URL: http://www.jstor.org/stable/40752203 . Accessed: 07/03/2012 21:24
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SoftBudget Constraints, Transition, andFinancial Systems

by Mathias Dewatripont and Grard Roland* Thispaper a of that the consurveys number contributions deal with "soft budget straint that of This problem," is,therefinancing loss-making enterprises. problem is particularly in economies is also pervasive market in but prevalent transition and Maskin [1995],thepaper economies. Dewatripont looksat soft Following constraints dynamic as commitment in of budget problems thepresence sunk costs.Various constraints analyzed: are dewaysto harden budget privatization, decentralization government, of decentralization credit, of and monopolization, reform. the constraints risk on banking Finally, paperlooksat theroleof budget and (JEL:P 20, P 34) taking innovation. /. Introduction "Softbudgetconstraints" a term coined by Kornai! whichmeans therefinancing of loss-making incentive enterprises wereone of themostimportant problemsof socialist economies. The importance and relevance of the concept of softbudget constraints now also acknowledged beyond socialist economies, due to well is knownexamples concerninglarge corporations (e.g., Chrysler)or in the banking sector(e.g., the bailout of the US S&Ls). Soft budgetconstraints the banking in sectorof East Asian economies are also believed to have played an important role in thesevere East Asian crisisof thelate nineties(Huang and Xu [1998]). Soft budgetconstraints have naturally been an important concernin transition economies,in easternEurope as well as in Asia. For example, theirrole has been stressed an obstacle to: (a) therestructuring loss-making as of because enterprises, relatedto thethreat bankruptcy; the sectoof (b) theylack thenegativeincentives ral reallocationof activity, continuedsubsidies to loss-makingState-Ownedas Enterprises(SOEs) preventsefficientprivate firmsfromoutbiddingthem for workers (see Castanheira and Roland [1995]); and (c) macroeconomicstabil* We thank Maskin having Eric for allowedus to borrow in 1 very heavily, sections to 3 ofthis from itself builds Dewatripont, Maskin,and Roland [1999],which paper, partly Werner uponMaskin [1996] and on Dewatripontand Roland [1997].We also thank Giith extensive for comments a first on draft. 1 Kornai 1 has the con[ 979],[ 1980],and[ 1992] inparticular shown roleofsoft budget in straints explaining emergence reproductionshortages socialist the and of in economies. Journal Institutional Theoretical of and Economics (JITE),Vol. 156(2000) 2000 MohrSiebeck- ISSN 0932-4569

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control under of becauseof thedifficulty keeping expenditures government ity, intheearly1990s). (see Litwack [1993]on Russia in in on of constraints enterprises economies The necessity hardening budget harden How in beenrecognized theliterature. to effectively transition clearly has of been less constraints however, frequently thesubject detailed has, analybudget in "reduced as is constraintsoften sis. Hardening form", a direct presented budget the without on choiceofaction an exogenous variable, questioning feasibilpolicy on in an important of theliterature of thischoice.Thisis partly because, part ity with are soft constraints identified subsidies.2 transition, budget Hardening budget to decision cutsubsidies. a is else constraintsthen policy nothing than simple and Maskin [1995],views initiated Dewatripont Another ofresearch, line by coninstitutions. budget Soft to as softbudget constraints endogenous specific be a where funding incentive straints seenas a dynamic are source, ita problem budinitial to to commit keepan enterprise a fixed or cannot government a bank, source in the an inefficiency that funding constraints Softbudget represent get. willbe knowthey but ex wouldliketo commit antenotto bail outfirms, they is of ex torefinance firm postbecausetheinitial the injection funds sunk. tempted under conditions of becomesthat theinstitutional Here,theinteresting question is constraints constraints. or there existhard soft which Hardening budget budget of the but not a thus simply direct variable, rather result institutional design. policy is sensitive the is of Anareawhere question institutional this design particularly cut have if of bailout banks. Indeed, macrostabilization programs drastically subsito SOEs havecontinued be bailed economies transition dies,inmany loss-making via suchas inter-enterprise andmost channels outviadifferent credits, importantly deterihas of the As bankcredit. a consequence, quality bankportfolios sharply illustrates wellthe Thisproblem a and orated, created "bad loan problem". very have of soft constraint Earlyanalysts thebad loanproblem phenomenon. budget solution as the (Begg emphasized needforbankrecapitalization theappropriate haveacand Portes [1993] and Mitchell [1994]).At thesametime, analysts could that expectaknowledged suchrecapitalization onlyoccuronce.Otherwise, banks'incentives. wouldseriously of bailouts tions future Despitethese dampen in as bank there clearwarnings, havebeenrepeated bailouts, for example Hungary to of in 1992-1994. Accumulation bad loansindeed strengthens pressures bailout their to to incentives banks improve fewer of and banks expectations bailouts give of This loanportfolio. is a clearexample thesoft syndrome. budget of on work focused seminal Kornai's budget mainly theconsequences thesoft He socialism. atunder of theemergence pervasive constraint, shortages namely to constraint the tributes causesof thesoft constraints, primarily political budget and politito that to thedesireof "paternalistic" is, governments avoid socially In (Kornai and Weibull [1983])the layoffs. hisownformalization callycostly ex firms thusundermines anteinand bailsoutloss-making simply government
2 See, for example,Aghion, Blanchard, and Burgess [1994] and Boycko, Shleifer,and Vishny[1995].

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in its of the centives. Understanding phenomenon paternalism, particular underin and is worthwhile itsownright hasan important in economy, pinnings political of Dewatripontand Maskin's [1995] analysis relevance. However, empirical has shown and centralized decentralized under soft constraint the banking budget a nor is of from logicalpoint view,paternalism neither necessary a suffia that, commitstress constraints. for condition soft cient Instead, they dynamic budget This investment.3 does notat all of in thepresence irreversible ment problems ofsoft is to mean paternalismnotrelevant ourempirical that understanding budget the The constraints. Dewatripont-Maskin framework, however, provides toolsto butalso beyond under soft constraints understand budget paternalism, paternalism socialism constraints the to andthereby understand causesof soft beyond budget is notan issue. in andtransition,cases where paternalism model of In that we spirit, use a variant theDewatripont-Maskin andshowthat on and constraints shedlight risk-taking incan of of thedegree hardness budget versus Japanese the and under market-oriented the dustrial Anglo-Saxon change the In particular, showthat Anglowe financial bank-oriented German systems. This harder constraints. mayhave Saxonmarket-oriented imposes budget system In it but of thedisadvantages short-termism also some advantages. particular, to resources finance and innovations, allowing gives moreflexibility financial in sectors. of faster expansion investmentnewinnovative and literature soft on constraints In thispaper, survey incentive we the budget for of for and analyzeitsrelevance transition itsimplications thecomparison fithe model In nancial 2, systems. section we detail Dewatripont-Maskin intheconof transiIn of text thesocialist 3, economy. section we lookattheeffects various market of constraints: tion reforms thehardening budget on product privatization, in reform. and market reform, financial Finally, seccompetition, government risk and the tion we consider issueof project innovation, the selection, taking, 4, under alternative financial hardness budget of constraint systems. as Problem 2. Soft Constraints a Dynamic Commitment Budget of model of Westart an adaptation theDewatripont-Maskin tothecontext sowith cialism. Consider following the adverse selection The government faces problem. a population firms, needing unit funds initial of one of in 1 inorder each to period their A proportion ofthese areofthe"good,quick"type: a begin project. projects After period, project successfully one the is and a (discompleted, generates gross financial return 1. Moreover, manager thefirm the of also counted) (possibly Rg> obtains positive (discounted) a net benefit Incontrast, is there workers) private Eg. a proportion - a) of bad and slow projects which no return (1 generate financial after period. terminated that one If at obtain private a benefit stage, managers Et.
Schaffkr[ 1981 also models lackofcommitment government to rescue the of not a j firm. loss-making

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if after a each Instead, refinanced, project (discounted) generates twoperiods gross benefit Initially, is common a financial return anda net(discounted) Eh. Rh private A simple result information. but are easilyfolknowledge individual types private bad is lows:If 1+Et<Rb+ Eh<2 andEh>0, refinancing projects sequentially optiwho to and malfor government, badentrepreneurs expect be refinanced the apply off be for initial The would, however, better ifitwereable financing. government with sinceitwould deter not bad tocommit torefinance projects, thereby managers from for initial badprojects E,<0. financing, provided applying allowstheuna devicewhich is Terminationhere, assumption,disciplining by bad types finance and of funds turn to informed onlygood ones.4 away provider if + is not rational Rh Eh> 1+Et: Once is termination sequentially Theproblem that value into its unit thefirst hasbeensunk a badproject, netcontinuation is positive arises. constraint in of the so that, theabsence commitment, soft syndrome budget economic feaofinvestmentsucha general is In this becauseirreversibility setup, hard constraints is to for the ture, challenge theory more explain prewhy budget in constraints soft thefirst are vailrather why than place. budget how reto This analysis be used as a starting can point understand transition to We constraint forms alleviate softbudget can the problem. now turn several suchreforms. and 3. Soft Constraints Transition Budget 3.1 Privatization that to aboveis related theassumption thegovresult The soft constraint budget insidethe and of benefits themanagers workers ernment caresabouttheprivate econin notion paternalism thesocialist of with Thisis consistent Kornai's firm. From constraint. that of as thesource thesoft privatizaperspective, budget omy creditor A of of tion the changes objectives theprovider funds. profit-maximizing of benefits insidthe on and the careonlyfor return projects notfor private would rid mean privatization,getting ofpaternalism, ridofsoft that ers.Does this gets by constraints? budget is under constraints for that Notefirst thecondition hardbudget privatization conwillbe hard There than easierto fulfill under budget ownership. government ownerunder condition the straints soonas Rh< 1, whereas relevant as government for + budget Eh-Et>0, thecondition hardening shipis Rh Eh-Et<'. Giventhat to under is constraints morestringent ownership compared private government will that result statics This budget implies there be harder ownership. comparative This to under constraints privatization ownership. is an application compared state if of can the idea ofthewell-known that incentives an agent be improved theprinand than socialwelfare, inparticis function lesscomprehensive cipal'sobjective
4 Thisdiffers of in a from static problem thespirit Stiglitz and Weiss [1981] where finance types. bad and all creditors atbestfinance types, atworst can

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idea to A similar interests theagent. very of to ularifitis insensitive theprivate of in be found Li [1992],also in thecontext privatizaherecan theone outlined of and tion, in a paperbySchmidtand Schnitzer [1993] on thedesign privatization agencies. the constraint can that Note, however, ifprivatization alleviate soft budget probthe budif will thelatter notbe eliminated Rp> 1! The modelshowsthat soft lem, of and evenafter privatization firms after the constraint problem maypersist get Wecan banks profit-maximizing). evengo onestep are reform when (i.e., banking will sinceit is soft constraints be widespread The further. modelpredicts budget a ex of drives wedgebetween anteandex posteffitheexistence sunkcoststhat is a nor of neither necessary From logicalpoint view, the paternalism thus ciency. In a sufficient condition softbudgetconstraints. the initialDewatripontfor the is but Maskin bank, model, investor nota government a profit-maximizing and constraints shouldbe observed a verygeneral as so softbudget phenomenon. soft constraints notas are from empirical the evidence, however, budget Judging The is less as suggested thisanalysis. challenge therefore to explain by pervasive in are soft constraints toexplain than why they notso prevalent a capitalist budget economy. of Inthemodel into the size above,we havenottaken account effects enterprise of constraints. on thedegreeof hardness softbudget mayhave a Biggerfirms suchas concentrationpolitof various levelsofEh-Et orofRhfor reasons, higher or externalities refrom smaller relative icalinfluence, value, liquidation collateral constraints smaller than etc. financing, and thusbe moreproneto softbudget firms this, Qian and Roland [1996]). see (on to constraints. To conclude, is route hard budget privatizationnotan automatic in economies where have Thisissueis particularly relevant transition governments to givingaway control existing management gone for"insider privatization", that as the teams, inRussia.In this case,Debande and Friebel [1996]stress fact of size (i.e., be "empire-builders"), managers havea bias in favor excessive may to firms if anything, and that reluctance thegovernment refinance the of reis, ducedbythefact that financial its stakein thecompany diminished privatis by ization: Sincethefinancial reward profit-maximizing of after strategies privatizationdoes notaccrueto thegovernment, should careat all abouttheprofit it why of thefirm's actions? Faure-Grimaud[1996] stresses Moreover, consequences thefact more aboutthefirm's future that, offering precise by signals profitability stockmarket worsen soft the convaluation), (through privatization may budget Ifthemanager confident thestock straint is that will market valuefuture problem: to in zero Rh profits appropriately, willnotbe afraid havetoreport profit perithey od 1,while otherwise might abstain from so! they altogether doing 3.2 Product Market Demonopolization The opportunity of refinancing cost a bad project also be raisedbyreducing can thecostofterminatingThe costofterminationin turn it. is related substitution to

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the acrossprojects, stressed Segal [ 1998].WhileSegal makes as possibilities by that soft the constraint attimes seenas theresult underprocan be of point budget vision cost-reduction bya monopolist order extract of in to subsidies from effort thegovernment, argument also be madedirectly the can within framework. our intotwo assumethat government spliteach project finances the can it Indeed, halves someefficiency for at becauseofincreasing returns scale. to cost, example In other two are and 1/2. words, entrepreneurs selected, eachreceives In case ofa in will the return onlybe QRJ2with 1,andsimilarly, case 6< goodproject, gross the ofa bad project is refinanced injecting in thesecondperiod, gross 1/2 that by is of will If that there demand the return be 6RfJ2. we assume onlyfor equivalent if havegoodprojects. what But onefull thegamestops both project, entrepreneurs if one projectis bad? The softbudgetconstraint problemcould remainif is for one that Assume, however, ifonly project good,itis optimal the 6R,J2>'/2. In instead refinancing badentrepreneur. of the toexpand activities its government of if in of other words, an increase capacity thegoodproject injection anthrough will whenever 1/2 bad other yields (2-0)Rg/2>dRfJ2, projects notbe refinanced Bad thus havebeenfinanced with they together a good project. projects getrefithere alwaysa is nanced ('-a). If aE, + {'-a)Eh<Q, then onlywith probability because at apply uniqueequilibrium whichonlygood entrepreneurs forfunds, in will it to a then bad entrepreneur notfind profitable submit project thefirst a place. As can be seen,demonopolization introduces between projects substitutability bad which harden constraints becausemoney refinancing projects for can budget use the can be diverted moreproductive by expanding good projects. to Thus, from eventhough bad may competition refinancing projects be expostprofitable, thus cost increases opportunity of soft the constraints, makbudget goodprojects ingrefinancing unprofitable. Decisions 3.3 Decentralization Government of 3.1 to Qian and Roland [1998] takea similar perspective thatin subsection toattitude + Eh-Ettobe toohigh becauseofthepaternalistic above,assuming Rh instead privatization, investigate of wardsinsiders. decentralizaHowever, they in remains control for as tionof government a method reducing Government Rh. its of thefinancing and decisions, thefocusis on altering incentives creating by decentralization. betweenlocal governments Qian and through competition so of reforms far. that is one of themainspecificities Chinese this Rolandargue incentives have takenplace in in enterprise Indeed,important improvements Mostofthese of Chinadespite absence privatization the improvements programs. which notprivately are and havetaken place in thetownship villageenterprises of after beginning thereform the but owned started process.3 booming
See, e.g., Whitzman and Xu [1993], Chh and Qian [1994], Bolton [1995], and Li [1995]. 5

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of 2 the frameQian andRolandinsert setup section intoa general equilibrium work with following the function Wfov government: the objective W=x(K,I)+y + u(z.) K where is thelevelofforeign investment theareaand/andz are,reinto capital the investment publicconsumption. and spectively, levelof publicinfrastructure of and firms manaMoreover, is thenetreturn financing refinancing (including y while of of benefits), x(.) andu(.) arethenetreturns thetwoforms gerial private investment of publicconsumption. and Assumepositive redecreasing marginal turns wellas complementarity as K between and/. The degree decentralizationdecisions be seento influence budget of of can the constraint facedbyfirms theintensity capitalmobility of acrossregions. through the function implies W bad and Maximizing objective refinancing firms, thusa soft ifandonlyif: constraint, budget

dx(KJ) dx(KJ) dK

,,-.

where left-hand oftheinequality thenetincrease ywhen unit the side is in one of funds usedto refinance firms, is bad whiletheright-hand is thenetreturn side to infrastructure investment public or level (z consumption beingtheequilibrium of Decentralization thenharden budget can the constraint of publicconsumption). firms becauselocal governments compete will with another attract one to foreign to morein infrastructure. In other decenwords, capital their region investing by tralization leadsto an increase dKldl(forsimplicity, and Rolandassume in Qian that dKldlis zeroforthecountry a whole, positive theregional as but at level). will funds towards infrastructure investment Regionalgovernments thusdivert and away frompublic consumption the purposeof fiscal competition. for bad will cost, Simultaneously, refinancing firms havea higher opportunity since Call level with u'z) hasincreased. z theequilibrium ofpublic consumption decentralized Provided are government. u{z)>Eh-Et + Rh-', onlygood projects financed under sinceentrepreneurs bad projects with them decentralization, expect to be terminated. that Note hardbudget constraints decentralization selfand are Once has fiscal over enforcing. thecentral government handed authority tothelocal government, itcannot recentralize fiscal expostfor sakeofbailthe authority will havespent their ingoutSOEs becausethelocalgovernments bythen budget. The commitment effects decentralization thusstrong moreeffective of are and than decisions prohibit budget to soft constraints which were taken in regularly the socialist but becauseof thelack of credible economy had no effect precommitment. It is interestingcompare results Qian and Roland [1998]with to the of those ofWang [1991],whosees decentralizationincreased as to autonomy given enterThe receive from central the fixed investment circulating and prises. latter planner which combined are a function. Increased capital using Cobb-Douglas production

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allowsenterprisesdecidehowtoallocate to funds between fixed investautonomy ment circulating and therisk that firms strategically capital, thereby raising might in in misallocate their funds order force government increase to the to spending if their favor. This can lead to inflation government is financed by spending of creation. Partial can leadtoa softening budget money enterprise autonomy thus constraints room strategic for distortions. becauseitgivesmore 3.4 Decentralization Credit Banking and of Reform 3.4.J Decentralization Credit of 2 with As we haveseen,thesetup section is compatible pureprofit-maximizaof inthepresence sunk of tionmotives thefunding of source. costs, Indeed, sequento maximization. Sincepritialprofit maximization be inferior ex anteprofit can if solvethesoft constraint vatization alonecannot budget problem Rb> 1,we must are necessary obtainhardbudget to conask whatother institutional changes of straints. Dewatripont and Maskin [1995] showthatthedecentralization in As element hardening constraints. intheprevious credit be a crucial may budget in this a sections, is achieved throughreduction Rh. on level Assume that continuation the valueofbad projects depends an effort creditor. assumethatthegross(disa to be exerted theinitial Specifically, by that is 0 and financial return a bad project is refinanced either orRh, of counted) informationthe to of assumea to be private that probability Rbis a. Finally, the to and initial who effort '/{a),assumed be increasing concost creditor, incurs vexina. will the creditor also be In thiscase,centralization credit of meansthat initial effort a* willfully level internala bad so the the refinancing firm, that chosen one of ize thebenefit monitoring: Rb = max{aRh-yf(a)}, and Rh= y/'(a*).

and is the creditor liquidity Under constrained, refinancing decentralization, initial effort. who must performed a newcreditor has notexpended be monitoring by and crediresources thefirm theinitial for effortandlimited Givenan expected contract the tor, amongnewcreditors, refinancing assuming perfect competition "successendsup being the willgrant deducted Ma from whenever bad project Rb is are no ful"(since,byassumption, resources availableiftheproject unsuccesswill creditor leadto: chosen thefirst level , ful).Given theeffort privately by
= Rh0 max'a[Rb- Ma]-y/(a)}J + '. L a

+ level a** is equal to yand satisfies: In equilibrium, effort this Rh=y/'(a**) value continuation than andtheassociated a** I/a**.Consequently, is lower a*, of as than IfRb< 1<Rb, decentralizationcredit, deoftheproject is lower Rb. Rb of constraint thefirm. the fined above,hardens budget

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if is of is in than1,decentralizationcredit Notethat, theabovesetup, /?f bigger of is worsethan since centralization, therefinancing bad projects notprevented, If creditor low butoccurswithinefficiently monitoring. one allowsendogenous in size ina market it to case,a marhowever, is possible showthat, this economy, In will keteconomy simply the financing pattern: equilibrireplicate centralized to the themselves will resources perform refinancing um,creditors havesufficient is thus (see Dewatripontand Maskin [1995]).Whiledecentralization unambigthan this under alternabetter exogenous centralization, is notalwaystrue uously tivemodelspecifications. whiletheDewatripont-Maskin showsthe Indeed, paper from benefits havingsmallbanks,there of havinglarger mayalso be benefits in banks. example, For Berglf and Roland [1997]showthat banks mayinvest ofprojects which theeffect increasing andthus has of a to pre-screening leading ex Such less softbudget constraints becauseof better ante monitoring. investin ments pre-screening induce economies scale,which of benefits banks. bigger Better antemonitoring however, reduce costsofexpostmonitorex also the may, worsens soft the constraint R%, ingandincrease which budget problem. is The general behind result that this decentralized finance insight maylead to the of This externalities reduce attractivenessrefinancing. suggests bond that that or equity will a finance typically involve harder constraint bankfithan budget a also stressed vonThadden [1995].6 nance, point by The abovemodelrests theassumption theinitial on that investor has one only unit funds, assumption suits of an that wellprojects with indivisibilities. important the that of reduces is Nevertheless, fundamental insight decentralizationcredit Rb robust holdsinmodels and alternative Huang and Xu [1998], using assumptions. for do constraints. assume projects fithat are They example, notassume liquidity investors haveconflicts interests respect therewho of with to nanced multiple by that when is strategy is tobe implemented a project refinanced. organization They receive abouttheright and conconflicting signals reorganization strategy, their flict interest respect thepayoff of with to obtain under each reorganization they for to reveal to plancanmakeitimpossible them truthfully their signal eachother. Thisthen leadstono refinancing tohard and constraints. Another modelis budget due to Povel [1995].Theretheexpostinefficiency between investors due the is toa warofattrition. agreement a restructuring is necessary refinance An on to plan a poorproject. Valuation each bankof thecontinuation of theproject value is by information eachofthetwobanks and tries convince other write to the to private downa larger fraction itsclaims. of Whilethetwobanks busybargaining, are the ex postvalueof refinancing project the If declines.7 bargaining expected delays arelongenough, refinancing poorprojects notprofitable. then of is
6 Other modelsexplaining of can outwhymultiplicity creditors changerefinancing comes includeBolton and Scharfstein [1996], Berglf and Thadden [1994], Dewatripont and Tirle [19941, Hart and Moore 19951. and Theprecise is there a probabilityeachmoment time theinis at in that assumption that formation leaks out to thepublicthat rescuenegotiations taking are place, whichthen makes rescue the or impossible ineffective.

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3.4.2 Competition newprojects from In transition of of and the economies, creation a decentralized system credit finanof debates aimedat hardenhas cial intermediation beenattheheart recent policy constraints of The on constraints enterprises. literature soft budget ingthebudget in of of in banking emphasized importance thequality theloanportfolio the has For in whether notbanks effective disciplining or are enterprises. exdetermining 2 of Berglf and Roland [1997]takea variant themodelinsection but ample, Assume attime a capital that 0 cost banks' endogenize opportunity ofrefinancing. to bank. overbythegovernmenta profit-maximizing Thiscapital of C()is handed as above.Attime1, the with is usedtofinance projects thesamecharacteristics Co in to new bankcan use thereturns (asperiod finance projects generated thefirst 0. bad financed time at and/or refinance projects to sumed be ininfinite to supply) financed 2: is the After time1,everythingexactly sameas insection Newprojects 2 at attime1 canbe refinanced time andwillbe,sinceRh> 1. cost on at 0? Willbad projects submitted time Thisdepends theopportunity be new the of at ofrefinancing projects time1,given possibility financing prothese net constraintstime theexpected return at will 2, budget jects.Sincethere be soft at to a newproject financed time1 is a(Rg-') + (' -a)(Rh- 2) whilethenetrehardbudget is a bad project Rh- 1. It can easilybe seenthat turn refinancing to no are at constraints obtain time1 (andthus bad project submitted time if: at 0)

a>0C~

Rg-(Rh-')

'

obtain time1. Itcanalso be seenthat at if constraints Instead, a<, soft budget of if with In other with increases Rhbutdecreases words, theexpected quality Rg. refieventhough constraints obtain is hard because, budget enough, projects high a it is a financingnewproprofitable,is less so than nancing bad project in itself conto wouldbe subject soft that budget by ject.Notethat assuming newprojects than has of at straints time thefinancing newprojects beenmadelessattractive 2, were ifhard constraints expected. budget are are soft constraints notan issueifnewprojects lessonis that budget Thefirst are soft constraints not Thismayexplain ofsufficiently quality. why budget good still and economies whythey in market a more phenomenon advanced pervasive The skills onlydeveloping. are where areintransition economies, entrepreneurial at constraints time1, newproare whenthere soft secondlessonis that, budget hard budunder of out arecrowded bytherefinancing bad projects. Indeed, jects while of to funds theamount C0(Rg-') can go to newprojects, getconstraints, that availablefor is it soft constraintsis onlyC0[a(Rg-')-('-a)] under budget at financed from are returns generated theprojects because:(i) fewer newprojects be must refinanced.8 time and(ii) badprojects 0,
8 Weassume > serve refito can from goodprojects always the so a '/Rg, that returns the the nance badones.

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3.4.3 Rent-Seeking Banks by is Another issue economies therelation between banks and important intransition banks Ithas becauseofsunk costs. maybe soft government. beenseenabovethat Berglf and Roland [1995] showthat may enterprises stillhave softbudget in constraints even in thecase in whichbankshave no intrinsic interest refifrom eveninthat firms, when i.e., case,banks R/,<'. Indeed, nancing maybenefit of This the exploiting softness government. will be thecase if thegovernment, which caresabouttotalwelfare, wouldfavor becauseRh Eh-Et>'. + refinancing Banksmaythen, under certain in to conditions, prefer rent-seeking,order obtain subsidies bailout, for than rather being hard towards Softness banks of enterprises. is here As related theweakness government. above,softness depend to of will on theaverage of as quality projects expressed a. by Takethesameframework theonejustanalyzed as above.Assume thegovthat ernment givesa bank first funds finance projects time Attime1, thebank to n 0. at can decideto be hard and liquidate projects instead ask thegovernment bad or to for subsidies refinance to those projects. bad Assume that bailout the money providedbygovernment coversthedifference between totalrefinancing the rejust ofthebankanditstotal funds time1, that ( 1- a) n- an Rg, at is which quirements we shallcall G. Assume, that cannot recover bailthis moreover, thegovernment outmoney, in which effect subsidies. can,however, It monitor use the represents of funds that bankcannot so the "takethemoney run"buthas to refinance and firms. Assume bankhas initially the attractedproportion a At ('-a) of bad projects. time1,itwillprefer towards andsoftness towards enterrent-seeking government to of if: prises compared terminationbad firms

G-('-a)n('-Rh)
or:

n[('-a)Rh-aRg]>0,

Rg+ Rh

As above,soft constraints obtained are whentheproportion good proof budget is belowa giventhreshold. thiscase, it is becausea lowera generates In jects lessrevenue time1 for bankandthus at the enablesittoobtain more subsidies. In other the the is of words, lower a, thelower theshare thebankinthecostsofrefibad nancing projects. Berglf and Roland [1995] further showthatinitial bankrecapitalization allowsbudget constraints be hardened, to that to provided banksare free choose thenumber projects want finance. is then theinterest banks set of to It in of to they aside enough reserves a commitment be hard. as to The lowerthea, thehigher this levelofreserves needbe,andthus smaller number projects can the the of that be financed. initial Low thus that average project quality implies hardening budget constraints a high has costin terms enterprise of hard Moreover, budget liquidity.

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of can constraints be obtainedif,at time 1, a proportion bad loans is takenaway for whichcan removebanks' incentives from banksand putintoa "hospitalbank", whichwill thatis costlyforthe government, and softness. However, rent-seeking It thenbear all thecost of refinancing. can be shownthatsuch a solutionis attracif a is above a giventhreshold.9 tiveforthegovernment only and Financial Systems Risk Taking, 4. BudgetConstraints, from can While hardbudgetconstraints deterbad entrepreneurs initiating projects, Thadden [1995] and Dewatripont and Maskin [1995] have pointedout that This may shed among good entrepreneurs. theycan also induce short-termism Germanor Japanese betweenthe morecentralized on some of thetrade-offs light market-oriented and themoredecentralized financialsystem bank-oriented Anglois Saxon financialsystemin whichbond and equityfinancing moreprevalent. model the abilityforgood intothe Dewatripont-Maskin introduce Specifically, to choose betweentheir good, quick projectthatyieldsRg> 1 and Eg entrepreneurs of return 0 after one periodand a good butslow projectthatyieldsa financial after but a gross financialreturn one period (and a privatebenefitEt if terminated) These projectsthus have a R>2 and a positive privatebenefitE{ if refinanced. value but,at theend of period 1, theycannotbe distinguished positivenetpresent from bad projects. Then compare a centralizedwitha decentralizedbankingsystem.Under cenfor therewill be softbudgetconstraints bad projectsif Rj; > 1 but the tralization, Underdecentralwill projectsof good entrepreneurs also be refinanced. long term there frombad projects, ization,since good slow projectscannotbe distinguished no refinancingof good slow projects if will be hard budget constraintsbut thancentralizabetter is Decentralization thennotnecessarily aRi + ('-a)Rb<'. to of view or even fromthe pointof view of returns tion fromthe welfarepoint hard undera short-termist budgetconstraint bank financing. Indeed, equilibrium to withdecentralized banking,the net return lendingis Rg-'. Under centralized but bankingwithsoftbudgetconstraints betterliquidityprovisionforgood prodominatesif + to the net return lendingis <*/?/(1- a) (/?-l)-l. The latter jects, can thusinduce + (1 - a) (RJ;- ')>Rg. The hardbudgetconstraint equilibrium aR bad behavior which more than offsetsthe gain fromdeterring "short-termist" started.10 from being projects long-term as the This discussionrationalizes idea thata market-oriented system, in Anglocan Saxon countries, be short-termist (Corbett [1987]) comparedto theJapanese financeand li(or German) bank-basedsystemwhich provides more long-term (Aoki [1990], Hoshi, Kashyap, and Scharfstein [1992]). On quidityto firms 9 Foran see banksolution, also Mitchell [1995]andAghion, of analysis thehospital 10The the and Maskin [1995]model Dewatripont endogenizes sizeofbanks. original

BOLTON, AND FRIES [1996].

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confrom soft the also theother hand, latter system suffers comparatively budget straints. instruments only good so that the it be to Ideally, would desirable havescreening This the real would selected not others. is not caseinthe be and the term long projects totheStiglitz inthis model. that world situation Note, however, compared pictured financial and Weiss [1981]model, hard the constraint decentralized system budget ofprojects: badprojects thelong-run projects. The and screens certain out good types between hardbudget constraints thecostsof short-termism, and The trade-off In is nottheonly can trade-off. Short-termism also haveadvantages. parhowever, and to in thefinancial be more flexible prove be faster injectticular, system may into sectors. see this, now, inthe To add as resources newinnovative ingfinancial in in Berglf and Roland [1997]model discussed section 3.4.2,thepossibility to thesecondperiod funding projects. of new simAssume, makethecomparison is centralization decentralization, there oneexogenous of and that unit plebetween at funds available both /= 0 andat/= 1 andthat newprojects att= 1 arehoarising and one unit funds newproof for Rn> mogenous havea return 1. At t= 1, using the use from = 0 t jects willyieldRn,whereas alternative of refinancing projects will be aR + ('-a)RJ? under decentralized and banking aR{-'-('-a)R^ under centralized As it there be refinancing will and banking. Rf?<R, is easyto see that soft constraints under centralization no refinancing hardbudget and and budget if constraints decentralization under (1) ('-a)R^<Rn-aR<('-a)R^.

In thiscase, thetrade-off between centralization decentralizationnotonly and is onebetween hard constraints versus short-termism. is nowan addiThere budget tional costof soft the for constraints, budget namely loss of finance newandpomore innovative under condition under the centralIndeed, (1), tentially projects. will be no funds t=' availableforfinancing new projects there at the ization, whereas will be ('+Rg) funds there availableunder decentralization. will This if createan inefficiency Rn-aRs [( 1- a) /?f-1,(1-)/?]. In thatcase, the exantereturn newprojects t= 1 is higher to at than ex antereturn projects the on from = 0 buttheold projects r nevertheless refinanced, the get including ex ante becausetheir continuation value is higher thanthe ones, unprofitable expected exantereturn newprojects. on New projects havethus harder a timebeingfunded whenwe havesoft budget and funded earlier not do constraints, thisfortworeasons:(i) becauseprojects interim returns contrast thesituation to where (in generate good,quickprojects wouldhavebeenfunded and wouldhaveto initially), (ii) becausenewprojects havea higher present net valuethan continuation ofinitially the value funded prois towards projects, new sincethey being are comjects.Thiscomparison "unfair" with whoseinitial costshavealready beensunk, is thus and pared projects ignored inthecomparison netreturns. leadsto a status bias inthesoft of This quo budget constraint equilibrium.

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between hardbudget the three basicdifferences thus Thisformulation implies soft constraint and constraint (1) budget equilibrium: soft budget equilibrium the budtheir from deter entrepreneurs starting projects; soft bad constraints to fail (2) to allow good entrepreneurschooserisky-but-profitable constraints long-run get newproa introduce status constraints (3) quo bias against budget projects; soft jects. in of of whenwe think thenature risk are Thesedifferences suggestive taking the werestressing In and to theUS relative Germany Japan. the1980s,analysts their in on roleoffinancial 1), discipline firms theUS (effect butwerelamenting At thatpoint, and Germany to relative Japan "short-termism" (effect 2). many was superior. the however, people Today, system peoplethought bank-oriented to newfirms allow them expand and of the are stressing ability theUS to fund This is consistent as a keyto theUS's perceived 3) (effect superiority. rapidly where there no newprojects are with with aboveanalysis: the Starting a situation is constraint the andwhere soft after initial the equilibrium budget period arising in of the st" tothe"short-termiequilibrium, balanceshifts favor theequisuperior whentheexpected and constraints short-lived librium with hardbudget projects is is of system slowto high. profitabilitynewprojects sufficiently Ifthefinancial of of the influences probability emergence (which change adaptto technological withlong-run a newprofitable economy projects), more"stable"bank-oriented "flexible" market-orientbeento be outperformeda more can by risk-taking thus suddenwhen to dedicated short-run ed economy progress technological projects lyaccelerates. References
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