Implicit benefits and financing

Abstract

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 may achieve lower financing costs, higher managerial effort, and better outcomes for both borrowers and lenders. This result is consistent with the continuing expansion of alternative financing despite 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 can explain expansion of financing with standard intermediation.