Changes

==Abstract==

This paper studies reputation formation and the evolution over time of the incentive effects of reputation to mitigate conflicts of interest between borrowers and lenders. Borrowers use the proceeds of their loans to fund projects. In the absence of reputation effects, borrowers have incentives to select excessively risky projects. If there is sufficient adverse selection, reputation will not initially provide improved incentives to borrowers with short credit histories. Over time, if a good reputation is acquired, reputation will provide improved incentives. General characteristics of markets in which reputation takes time to work are identified.

==The Model==

There are four facts about returns:

It is clear that:

#If <math>r_{T}^{g}>G\,</math> or if ( <math>r_{T}^{g}>\frac{G-\pi B}{1-\pi }\,</math> and <math>r_{T}^{b}>G\,</math> ) then no loans are made

#If <math>r_{T}^{g}>\frac{G-\pi B}{1-\pi }\,</math> and <math>r_{T}^{b}\leq G\,</math> then the unique equilibrium has <math>r_{T}=r_{T}^{b}\,</math>, and <math>GB\,</math> types choose <math>B\,</math> projects

:<math>G>r>\frac{G-\pi B}{1-\pi}\,</math>

This gives us the first Lemma:

'''Lemma 1''': At the final period <math>T\,</math>, (a) all borrowers offer a debt contract with the lowest interest rate that provides an expected return of <math>r\,</math>; (b) all borrowers who can repay do so; and (c) Only borrowers for whom beliefs suggest a high enough probability of being a <math>G\,</math> type will get a loan in period <math>T\,</math>.