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About this book

In this book Christian Prem features new innovations on several levels. On a conceptual level he presents a complete restructuring and modularisation of the field of lending theory. On a formal level he bestows great care on providing precise definitions and promotes notational standardisation. On a technical level the development of an algorithm to solve repayment games automatically is thoroughly documented. Eventually, new theoretic results on the performance of various credit schemes are established, the quality of existing lending schemes is scrutinised and new more efficient mechanisms are presented. The content therefore inspires theorists as well as it provides well-grounded advice to practitioners in the lending industry. Altogether this thesis is a major step towards improving the quality and applicability of lending theory.

Table of Contents

Frontmatter

General Topics

Frontmatter

Chapter 1. Start: The meaning of credit

Abstract
Is research into credit contracts valuable to people? Or is it just brain callisthenics in the ivory tower of science? The first chapter of this book will
  • define what credit is,
  • demonstrate why credit is of enormous social relevance and
  • explain how this valuable tool releases its incredible potential.
Credits change peoples lives! It is of vital importance to understand them well.
Christian Prem

Chapter 2. Structure: The structure of credit contract theory

Abstract
This chapter and the rest of part I are devoted to an in depth analysis of the structure of lending theory. A description of the basic structure of credit contracts has been given in chapter 1 already (see service, uncertainty phase and return service on p. 3). We now focus on gaining a clear conceptual understanding of the various aspects and details of lending theory.
Christian Prem

Chapter 3. Specifications: The modules and their treatment in the literature

Abstract
This chapter provides a literature review. It is, however, not a standard review that takes individual publications and repeats their results. In contrast, its innovation is to proceed in a cross-sectional fashion. It restructures the content along the modules of lending theory identified in the previous chapter (see 2.1). The emphasis lies on carving out the fundamental working principles of each module.
Christian Prem

Chapter 4. Simplicity: The interplay of product layer modules

Abstract
Whilst monolithic models combine a whole chain of interacting modules, the modular research strategy focuses on individual modules and their improvement by abstracting the rest of the system to simple input and output signals. And as Nisan and Schocken emphasise in the context of computer science: “. . . a good modular design implies just that: You can work on the individual modules independently, while completely ignoring the rest of the system.”
Christian Prem

Chapter 5. Standardisation: The standardisation of credit contract theory

Abstract
So far we have discussed the possibility to and the benefits of organising lending theory in modules. This section will analyse some general structures of lending theory, unrelated to particular modules. The analysis will lead to a number of recommendations for how to improve lending theory by using uniform concepts and standards.
Christian Prem

Contributions to Selected Topics

Frontmatter

Chapter 6. Joint liability can cause adverse selection instead of resolving it

Abstract
How does joint liability affect financial inclusion? Armend´ariz and Morduch repeatedly argue that it makes credit cheaper (in terms of nominal interest rates) and can therefore “lure deserving safe types [of borrowers] back into the market.” [AM10, p. 104] In contrast, I show that joint liability is expensive (in terms of expected repayment, maximum repayment and risk) and that in fact less borrowers will be eligible for credit.
Christian Prem

Chapter 7. Collateralisation shifts risk towards borrower – A formal proof

Abstract
This article formally proves that if, in a standard debt contract, collateral is increased and interest is decreased simultaneously in a way that keeps expected repayment constant, then for the borrower the resulting probability distribution of payoff is a mean preserving spread of the original one. Together with a theorem from [RS70] the consequence is that risk-averse borrowers prefer loans with little collateral. The result has numerous implications on the evaluation and the contracting module of lending theory.
Christian Prem

Chapter 8. Meaning of moral hazard is ambiguous – An improved definition

Abstract
This article reflects on the notion ‘moral hazard’, a concept that refers to some undesired action of the agent in a principal agent setting. Building on the elaborate investigation of [RC12] and after an analysis of previous attempts to define moral hazard, a new definition is proposed. Subsequently, this general definition is applied to credit contract theory.
Christian Prem

Chapter 9. An algorithm that can solve repayment games automatically

Abstract
Lending theory is full of research on repayment games. There are games with individual liability, with joint liability, with joint liability and social sanctions, with joint liability and message games, with partial joint liability and an even greater multitude of repayment games can be imagined where repayment is made cooperatively or non-cooperatively, simultaneously or sequentially, with punishment functions that are symmetric or asymmetric, with two or more borrowers, and so on.
Christian Prem

Chapter 10. Perverse effect of joint liability vanishes with adaptive punishment

Abstract
The perverse effect of joint liability (JL) refers to a situation where borrowers under individual liability (IL) would repay but do not do so under JL. To counteract that negative effect of JL the literature suggests more flexible lending schemes like implicit joint liability ([DQFG16]) or optimised partial joint liability ([All16]). I claim that the perverse effect is an artefact of a too rigid punishment function and I show how it disappears with adaptive punishment.
Christian Prem

Chapter 11. Social sanctions coordinate and motivate

Abstract
This article examines the effects of social sanctions on various repayment games. Compared to the model in [BC95] the avoidable-harm-concept of social sanctions is kept, but the setup is simpler and cleaner. And yet, the two main roles of social sanctions can be clearly demonstrated: its incentive effect and its coordination effect. Moreover, the model presented here reaches beyond the results in [BC95] in several ways. Firstly, all shapes are considered ([BC95] only consider the unrestricted shape). Secondly, group size is increased to three ([BC95] only analyse groups with two borrowers). Thirdly, social sanctions are combined with individual liability ([BC95] only examine social sanctions in conjunction with joint liability).
Christian Prem

Chapter 12. Cross-reporting can eliminate equilibrium punishment load

Abstract
This article analyses the effects of cross-reporting on repayment games. The joint liability message game in [RS13] is presented and corrected. The joint liability message game in [RS04] is stated and extended to a richer set of states of nature. Finally, a new cross-reporting game in combination with individual liability is presented that features zero equilibrium punishment load and only unique equilibria for all realisations of a three-valued ability to repay.
Christian Prem

Chapter 13. Outlook: Modularisation and standards improve research quality

Abstract
This final chapter presents a vision for the future of credit contract theory and makes three proposals to improve its quality and applicability.
Christian Prem

Backmatter

Additional information

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