Evidence for Dynamic Contracts in Sovereign Bank Lending

This paper presents direct evidence for self-enforcing dynamic contracts in sovereign bank lending. Unlike the existing empirical literature, its instrumental variables method allows for distinguishing a direct influence of past repayment problems on current spreads (a "punishment" effect in prices) from an indirect effect through higher expected future default probabilities. Such a punishment provides positive surplus to lenders after a default, a feature that characterizes dynamic contracts. Using data on bank loans to developing countries between 1973-1981 and constructing continuous variables for credit history, we find evidence that most of the influence of past repayment problems is through the direct, punishment channel.