RELATIONSHIP BANKING. Earnings&Growth, Inc., can choose one of two projects: safe or risky. The safe project yields $141 with probability 0.92 and zero with probability 0.08, whereas the risky project yields $160 with probability 0.60 and zero with probability 0.40. Be careful; tisky is not 50-50). Each project requires an investment of $100, which Eamnings&Growth (E&G) must borrow. The bank cannot observe the firm's choice of project. Everyone is risk neutral, and the risk-free rate is zero. 2. Find the maximum interest rate the bank can charge and still have E&G choose the safe project. b. Find the rate at which the bank breaks even (eams only the cost of funds). In a one-period relationship, can we finance the efficient project Now suppose the bank has a long-term relationship with E&G. The firm seeks two successive $100 loans to finance projects in periods 1 and 2. The bank promises to extend credit ir. period 2, at interest rate is, on the condition that E&G repay its loan from period 1. c. Suppose the bank in period 2 charges its preferred rate, iz. Given iz find the maximum interest rate in period 1 for which E&G prefers the safe project. Explain why this rate differs from the rate that kept the firm safe in part (2) d What is the first-period interest rate at which the bank breaks even on the two-period contract Explain why this breakeven rate differs from the breakeven rate in part b). e. If the market for long-term contracts is competitive, what is the equilibrium first-period interest rate? f. If E&G defaults in period 1, can they switch to a different bank to get a loan in period 2? Why or why not? g. Does the resolution of the moral hazard rely on the reputation of the borrower, or of the lender? Explain. h Suppose the bank suspected that the borrower was entering the two-period contract to obtain just a single loan in period 1. Would the bank still offer the contract? Why or why not? RELATIONSHIP BANKING. Earnings&Growth, Inc., can choose one of two projects: safe or risky. The safe project yields $141 with probability 0.92 and zero with probability 0.08, whereas the risky project yields $160 with probability 0.60 and zero with probability 0.40. Be careful; tisky is not 50-50). Each project requires an investment of $100, which Eamnings&Growth (E&G) must borrow. The bank cannot observe the firm's choice of project. Everyone is risk neutral, and the risk-free rate is zero. 2. Find the maximum interest rate the bank can charge and still have E&G choose the safe project. b. Find the rate at which the bank breaks even (eams only the cost of funds). In a one-period relationship, can we finance the efficient project Now suppose the bank has a long-term relationship with E&G. The firm seeks two successive $100 loans to finance projects in periods 1 and 2. The bank promises to extend credit ir. period 2, at interest rate is, on the condition that E&G repay its loan from period 1. c. Suppose the bank in period 2 charges its preferred rate, iz. Given iz find the maximum interest rate in period 1 for which E&G prefers the safe project. Explain why this rate differs from the rate that kept the firm safe in part (2) d What is the first-period interest rate at which the bank breaks even on the two-period contract Explain why this breakeven rate differs from the breakeven rate in part b). e. If the market for long-term contracts is competitive, what is the equilibrium first-period interest rate? f. If E&G defaults in period 1, can they switch to a different bank to get a loan in period 2? Why or why not? g. Does the resolution of the moral hazard rely on the reputation of the borrower, or of the lender? Explain. h Suppose the bank suspected that the borrower was entering the two-period contract to obtain just a single loan in period 1. Would the bank still offer the contract? Why or why not
