The Effects of Market Structure and Reputation on Bankruptcy and Banks’ Performance

Based on the sunk cost model on soft budget constraint (SBC) by Dewatripont and Maskin (1995), we introduce a reputation model in the debt market. In this model, we further extend Alexeev and Kim(2004)’s prototype model to study the effects of opportunistic borrowers whose expected payoff are non‐negative after their quality is known to the market as a signal of informing the bank’ type to the market. While financing such borrowers repeatedly seems irrational, it has been justified economically and non‐economically by the sunk cost model. We find that a bank has incentives to liquidate or refinance the borrowing firms, depending on their commitment to short‐term performances and that the market structure or the multiplicity of banks play a critical role in decisions to default such firms, and that the number of banks playing tough against such firms has a negative effect on such default decisions.