Asset Substitution and Credit Reputation Equilibrium

Abstract

The purpose of this paper is to study the asset substitution problem in a credit market with repeated borrowing. In literature this agency problem between the borrower and the lender has been used to explain various financial phenomena. Applying the concept of sequential equilibrium, this study demonstrates that the role of reputation in a credit market can deal with the asset substitution problem without contracting cost. The nature of the equilibrium interest rate is explored and the welfare implication is discussed. Since the agency costs can be reduced in this equilibrium, the explanations based on asset substitution argument need to be examined more carefully.