SOFT BUDGET CONSTRAINTS AND CREDIT CRUNCHES IN FINANCIAL TRANSITION

This paper provides a framework for understanding the lingering proble m of soft budget constraints in many transition economies even after t he macroeconomic situation has been stabilized and a sound banking sys tem has been introduced. We show that soft budget constraints can pers ist and even coexist with credit crunches, as the existing evidence fr om transition economies seems to indicate. As in Dewatripont and Maski n (Credit and efficiency in centralized and decentralized economies, R eview of Economic Studies, 1995), the existence of sunk costs in exist ing loans may also give rise to soft budget constraints when banks the mselves are subject to hard budget constraints and have outside option s. We endogenize the outside option by allowing banks to allocate avai lable funds between new lending and refinancing of old loans. The opti on to invest in new lending hardens budget constraints when the averag e quality of investment projects is high and varied. Otherwise soft bu dget constraints may persist. In the latter case, refinancing of old l oans crowds out new finance, giving rise to credit crunches on new loa ns. By screening and monitoring firms banks can improve the relative p rofitability of new lending and break out of soft budget constraint eq uilibria. Unlike Dewatripont and Maskin, larger banks may be harder th an smaller banks because they have the resources and higher incentives to invest in screening and monitoring. (C) 1997 Elsevier Science B.V.