REPUTATION AND DISCRETION IN FINANCIAL CONTRACTING

We explain the use of legally unenforceable, discretionary financial c ontracts in circumstances where legally enforceable contracts are feas ible. A discretionary contract allows a contracting party to choose wh ether or not to honor the contract. It is shown that such a contract l iquefies reputational capital by Permitting it to be depreciated in ex change for the preservation of financial capital and information reusa bility in financially impaired states. In addition, discretionary cont racts foster the development of reputation. This explains discretion a mong highly confident letters, holding-company relationships, mutual-f und contracts, bank loan commitments, and other financial and nonfinan cial contracts.