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This paper analyzes in a formal model the problem of achieving financial discipline in a transitional economy with bank-intermediated finance. Even if banks have no intrinsic interest in refinancing unprofitable firms, they may still exploit the softness of government. By gambling for government bailouts, banks contribute to softening the budget constraints of enterprises. We show that the poor quality of loan portfolio, the absence of collateral, and low bank capitalization are key elements explaining soft budget constraints and repeated bank bailouts in transitional economies. Bank reserves help in hardening budget constraints, but high initial levels of capitalization are necessary to mitigate potential negative effects of a credit crunch for enterprises. We demonstrate that the trade-off between hardness and enterprise liquidity is more severe when loan portfolios are of poor quality. A similar trade-off arises if a bank invests in screening or monitoring projects to improve the quality of portfolios. Under certain conditions, the government should make capitalization contingent on banks investing in monitoring and screening in order to obtain hard budget constraints rather than to let banks use reserves for such investments. We further show that transfers of all nonperforming loans to a separate institution, a hospital agency, is never optimal, whereas partial transfers may serve to harden budget constraints. J. Japan. Int. Econ., December 1995, 9(4), pp. 354–375. ECARE, Université Libre de Bruxelles, Brussels, Belgium.

In this paper, we focus on soft budget constraints for enterprises that are financed by banks in transition economies and analyze several theoretical models as variants of a basic sequential model. Despite various transmission channels for soft budget constraints, all models share the same sequential structure in which soft budget constraints arise due to the endogenous lack of credibility for liquidating a project instead of refinancing it. All also have the same property that refinancing is optimal ex post for the decision maker. Hence, mechanisms for hardening the budget constraint require endogenously restoring the credibility of liquidation.J. Comp. Econom.,March 1998, 26(1), pp. 18–40. SITE, Stockholm School of Economics, and CEPR, Box 650, S-11383 Stockholm, Sweden; and ECARE, Université Libre de Bruxelles, and CEPR, 39 av. Roosevelt 1050, Bruxelles, Belgium.

This paper provides a framework for understanding the lingering problem of soft budget constraints in many transition economies even after the macroeconomic situation has been stabilized and a sound banking system has been introduced. We show that soft budget constraints can persist and even coexist with credit crunches, as the existing evidence from transition economies seems to indicate. As in Dewatripont and Maskin (Credit and efficiency in centralized and decentralized economies, Review of Economic Studies, 1995), the existence of sunk costs in existing loans may also give rise to soft budget constraints when banks themselves are subject to hard budget constraints and have outside options. We endogenize the outside option by allowing banks to allocate available funds between new lending and refinancing of old loans. The option to invest in new lending hardens budget constraints when the average quality of investment projects is high and varied. Otherwise soft budget constraints may persist. In the latter case, refinancing of old loans crowds out new finance, giving rise to credit crunches on new loans. By screening and monitoring firms banks can improve the relative profitability of new lending and break out of soft budget constraint equilibria. Unlike Dewatripont and Maskin, larger banks may be harder than smaller banks because they have the resources and higher incentives to invest in screening and monitoring.