The design of bank loan contracts

The unique characteristics of bank loans emerge endogenously to enhance eff iciency in a model of renegotiation between a borrower and a lender in whic h there is the potential for moral hazard on each side of the relationship. Firm risk is endogenous and renegotiated interest rates on the debt need n ot be monotone in firm risk. The initial terms of the debt are not set to p rice default risk but rather are set to efficiently balance bargaining powe r in later renegotiation. Loan pricing may be nonlinear, involving initial transfers either from the borrower to the bank or from the bank to the borr ower.