Reputation and the Soft-Budget Constraint

We study the role of reputation in dealing with the soft-budget constraint. We examine whether the reputation of a borrower can lead to repayment in an environment where enforcement is weak. We also introduce lenders' reputation and examine how this impacts on the allocation of borrowers. We find that reputation can harden budget constraints and improve welfare, although it can never fully eliminate softness. We also show that lenders who acquire a reputation for being tough can earn higher profits than lenders with reputations for being soft. This provides a mechanism for the endogenous emergence of hard-budget constraints