Soft budget constraints and credit crunches in financial transition

This paper provides a framework for understanding the lingering problem of soft budget constraints in many transition economies even after the macroeconomic situation has been stabilized and a sound banking system has been introduced. We show that soft budget constraints can persist and even coexist with credit crunches, as the existing evidence from transition economies seems to indicate. As in Dewatripont and Maskin (Credit and efficiency in centralized and decentralized economies, Review of Economic Studies, 1995), the existence of sunk costs in existing loans may also give rise to soft budget constraints when banks themselves are subject to hard budget constraints and have outside options. We endogenize the outside option by allowing banks to allocate available funds between new lending and refinancing of old loans. The option to invest in new lending hardens budget constraints when the average quality of investment projects is high and varied. Otherwise soft budget constraints may persist. In the latter case, refinancing of old loans crowds out new finance, giving rise to credit crunches on new loans. By screening and monitoring firms banks can improve the relative profitability of new lending and break out of soft budget constraint equilibria. Unlike Dewatripont and Maskin, larger banks may be harder than smaller banks because they have the resources and higher incentives to invest in screening and monitoring. (C) 1997 Elsevier Science B.V.