Banks in International Trade: Incomplete International Contract

Enforcement and Reputation

+
Morten Graugaard Olsen
y
November 11, 2010
JOL MAIKL1 IAILI
ALsliacl
Lanks aio impoilanl facililalois of inloinalional liaoo. Losioos piovioing liquioily lhoy
guaianloo paymonl foi aiouno a lflh of woilo liaoo, in pailiculai whon lho conliacl onfoico-
monl of lho impoiling counliy is woak.
Lul if conliacl onfoicomonl is loo woak lo liusl lho paymonl of an impoiloi, why liusl
lho impoiloi`s Lank I aiguo lhal iopulalional mochanisms can piovioo lho answoi. Woak
conliacl onfoicomonl inliooucos a limiloo-onfoicomonl pioLlom, as lho impoiloi can ionogo
on paymonl afloi iocoipl of lho shipmonl, which iopoaloo inloiaclion allovialos. Foi impoilois
loo infioquonlly ongagoo in inloinalional liaoo lo oslaLlish a ciooiLlo iopulalion, a Lank can
incioaso ciooiLilily Ly guaianlooing mulliplo impoilois, Lul only if oxpoilois can colloclivoly
punish lho Lank shoulo il ionogo on ono of lhom. Mulually conlimoo Lank guaianloos ovoi-
como lho nooo foi colloclivo punishmonl ano fuilhoi incioaso ciooiLilily as Lilaloial claims
Lolwoon Lanks ioouco lho nol amounl lo Lo ionogoo on. In olocl, mulually conlimoo guai-
anloos pailially liansfoim inloinalional oLligalions inlo oomoslic oLligalions, which aio moio
oasily onfoicoo.
Whilo lhis papoi focusos on Lanks, iopulalional mochanisms can also shoo lighl on Lolh
laigo inloimooiaiios ano oxpoil ciooil agoncios.
JLL cooos: C78, F10, G21, L11, L14
Koywoios: 1iaoo Financo, Iopoaloo inloiaclion, Conliacl Lnfoicomonl, Iopulalion

I thank Pol Antras, Oliver Hart, Elhanan Helpman, and Andrei Shleifer for invaluable guidance. I also
thank Philippe Aghion, E Benmelech, John Campbell, Steve Cicala, Raluca Dragusanu, Adam Guren, David
Hemous, Sabrina Howell, Greg Lewis, Marc Melitz, Alp Simsek, and Vania Stavrakeva for insightful conversa-
tions, and the parcipants of the Harvard International Lunch and Seminar for helpful comments. All remaining
errors are my own.
y
Morten Graugaard Olsen, Department of Economics, Littauer Center, Harvard University, Cambridge, MA
02138, mgolsen@fas.harvard.edu.
1 Introduction
Lanks aio impoilanl facililalois of inloinalional liaoo. Losioos piovioing liquioily lhoy guai-
anloo paymonl foi aiouno a lflh of woilo liaoo. As aiguoo Ly Iooiik (2000) ano Iauch
(2001), inloinalional conliacl onfoicomonl is woak ano Lank guaianloos piovioo a way of on-
suiing liaoo, ospocially whon local couils aio unaLlo oi unwilling lo onfoico paymonl fiom
impoilois. 1his papoi asks lho quoslions of why ano how Lanks can poifoim lhis iolo, ano
aiguos lhal iopulalion is ciucial. 1hough lho papoi is nol lho lisl lo foimalizo incomplolo
inloinalional conliacl onfoicomonl, il omphasizos iopulalion as an impoilanl mochanism foi
ovoicoming lhis ano aiguos lhal Lanks ano olhoi laigo onlilios in inloinalional liaoo can
Lo viowoo as mochanisms foi oslaLlishing ciooiLilily lhiough iopulalion.
I oovolop a oynamic moool wilh iopoaloo inloiaclion Lolwoon Luyois ano sollois in a woilo
in which conliacls Lolwoon inloinalional pailios cannol Lo poifoclly onfoicoo ano analyzo lho
iolo of iopulalion as a suLslilulo foi foimal onfoicomonl of conliacls. Wilh impoifocl conliacl
onfoicomonl, lho impoiloi can iofuso paymonl, Lul lho iosulling loss of fuluio coopoialion
soivos as an inconlivo foi honosl Lohavioi. 1his inconlivo is of lilllo valuo lo lims ongaging in-
fioquonlly in inloinalional liaoo oi wilh fioquonl now pailnois. I show lhal foi such impoilois
ciooiLilily of paymonl can Lo oslaLlishoo lhiough lho inlioouclion of a Lank lhal sequentially
guaianloos paymonl lo oxpoilois on Lohalf of mulliplo impoilois if oxpoilois can colloclivoly
punish oovialions againsl any ono of lhom. 1his assumplion can Lo oioppoo Ly having a local
Lank in lho oxpoilois` counliy conlim lho guaianloos. 1ho inlioouclion of lwo Lanks mulually
conliming oach olhoi guaianloos fuilhoi inliooucos nolling": wilh mulual oLligalions, lho
Lanks can al mosl ionogo on lho nol amounl oulslanoing, ano ciooiLilily is fuilhoi incioasoo.
Losioos answoiing lho quoslion of how Lanks can piovioo guaianloos Ly oslaLlishing highoi
ciooiLilily lhiough sizo, lho moool answois lho quoslion of why Lanks (as opposoo lo olhoi
laigo onlilios) piovioo lhoso guaianloos, Ly aiguing lhal onfoicomonl of lho conliacl wilh lho
impoiloi is Losl achiovoo Ly a Lank alioaoy ongagoo in moniloiing lhal impoiloi.
1ho moool ioplicalos lho mosl salionl foaluios of lho inousliy: il is highly conconlialoo,
lho piovioois of guaianloos aio piooominanlly local Lanks, Lanks ongagoo in long slanoing
iolalionships conlim lho guaianloos, ano lho oomano foi such guaianloos can incioaso ouiing
limos of uncoilainly. Il fuilhoi shows lhal a small chango in lho conloonco in lho guaianlooing
Lank can loao lo oisconlinuous changos in ils ciooiLilily foi issuing guaianloos. 1his is in lino
wilh oLsoivalions fiom lho Asian ciisis in lho 1000s whon Lanks in alocloo counliios quickly
losl ciooiLilily. 1ho moool sopaialos Lanks` iolos as piovioois of liquioily ano guaianloos ano
aiguos lhal lnancial ciisos can alocl liaoo lhiough Lolh.
1ho moool fuilhoi oomonslialos how lho iolalivo impoilanco of iopulalions is highoi foi
counliios wilh woakoi conliacl onfoicomonl ano foi spocializoo gooos, consislonl wilh lho lno-
ings lhal lhoso aio lho lypos of gooos foi which Chinoso olhnic nolwoiks aio mosl impoilanl
1
(Iauch ano 1iinoaoo, 2002). Colloclivo punishmonl Lolwoon momLois allows lhoso nolwoiks
lo funclion as onfoicomonl mochanisms such lhal iopulalion can suLslilulo foi logal onfoico-
monl. Whilo lhis moool is aLoul Lanks, ano lho focus is on how Lanks facililalo iopulalional
mochanisms, lhoso mochanisms aio nol uniquo lo Lanks. 1ho samo mochanisms can shoo lighl
on lho impoilanco of laigo inloimooiaiios ano oxpoil ciooil agoncios in inloinalional liaoo:
lhoy aiiso lo onsuio ciooiLilily of honosl Lohavioi whoio inoivioual lims aio unaLlo lo oo so.
Allhough Lanks` iolos as piovioois of liquioily aio impoilanl, lho main focus of lhis papoi is
on lhoii iolo as piovioois of guaianloos, ano lho piovision of liquioily is lioaloo as an oxlonsion.
Cloaily, guaianloos can Lo analyzoo only in a solling whoio conliacl onfoicomonl is impoifocl.
1o lhis ono, lho moool analyzos a holo-up pioLlom Lolwoon an impoiloi (a oisliiLuloi) ano
an oxpoiloi (a piooucoi) ooaling on an opon accounl Lasis: lho oxpoiloi makos ano ships lho
gooos ano Loais lho pioouclion cosl, whoioas lho impoiloi oains lho iovonuo fiom solling lho
gooos. 1ho impoiloi is ioquiioo lo pay only whon sho has lho gooos in hano, Lul onco sho
ooos, sho can ooclaio lhom lo Lo of low qualily ano iofuso lo pay as couils aio only impoifoclly
aLlo oi willing lo foico hoi lo oo so. 1ho oxpoiloi ioalizos lhis Lofoio shipmonl, ano in a
non-iopoaloo fiamowoik lho quanlily of liaoo is consliainoo (analogous lo unooi-invoslmonl
in lho moool Ly Giossman ano Hail (1086)).
1hoio is wioospioao ovioonco lhal lims ioly on iolalional conliacls in oiooi lo onsuio
coopoialion fiom lhoii pailnois (Lllickson, 1001 ano Kiops, 1006). In lho conloxl of inloina-
lional liaoo, Iauch ano 1iinoaoo (2002) ano Iauch (2001) aiguo lhal nolwoiks aio impoilanl
piooiclois of inloinalional liaoo, as lho possiLlo osliacizalion fiom lho communily givos an
inconlivo foi honosl Lohavioi. Anli`as ano Foloy (2010) lno lhal a laigo US oxpoiloi is moio
likoly lo liusl Luyois lo pay afloi iocoipl of gooos in lho caso of long-lasling iolalionships.
In lho piosonl papoi, impoilois ano oxpoilois aio oxogonously malchoo, ano lho inloiaclion
is iosliicloo lo lako placo every other poiioo. Simplo liiggoi slialogios allow lhom lo achiovo
highoi liaoo lhan foi a non-iopoaloo inloiaclion, Lul lho inloiaclion is loo infioquonl lo achiovo
lho piolls maximizing quanlily. 1hough lho moool is fiamoo in loims of infioquonl liaoo, olhoi
inloipiolalions such as a low oiscounl facloi oi high luin-ovoi ialo aio ioaoily possiLlo. 1ho
inlioouclion of a Lank lhal guaianloos paymonl lo oxpoilois on Lohalf of mulliplo impoilois
every poiioo can incioaso ciooiLilily. Yol, lhis is nol solf-ovioonl. In placo of an agoncy
pioLlom Lolwoon lho impoiloi ano lho oxpoiloi, lho inlioouclion of a Lank cioalos lwo now
agoncy pioLloms: Lolwoon lho impoiloi ano lho Lank ano Lolwoon lho Lank ano lho oxpoiloi.
1ho Lank can piovioo guaianloos only if Lolh now iolalionships allow laigoi quanlily of liaoo.
Fiisl, lhis suggosls lhal lho issuoi of lho guaianloo shoulo Lo a Lank localoo in lho counliy of
lho impoiloi ooaling wilh lho impoiloi in olhoi iospocls, as lhis allows foi Lolloi moniloiing
ano lhoioLy Lolloi onfoicomonl. Socono, lho moio fioquonl inloiaclion wilh oxpoilois onaLlos
lho Lank lo oslaLlish a sliongoi iopulalion ano lhoioLy a highoi cosl of ionoging lhan oach
2
of lho inoivioual impoilois (who only iaioly impoil) coulo inoivioually. In olocl lho moio
fioquonl inloiaclion woiks lo incioaso lho oiscounl facloi.
Diiocl guaianloos lo oxpoilois, howovoi, ioly Lolh on sumcionl pioll foi lho Lank ano lho
aLilily of oxpoilois lo colloclivoly punish lho Lank Ly wilhholoing fuluio Lusinoss shoulo il
ionogo on ils oLligalions lo ono of lhom. Iosilivo piolls aio nocossaiy lo inlioouco a cosl fiom
ionoging in loims of fuluio piolls, ano colloclivo punishmonl implios lhal all fuluio piolls aio
losl Ly ionoging in olhoi poiioo. I show lhal lho unooiwiiling of guaianloos Ly an aooilional
Lank in lho oxpoiling counliy oliminalos lho nooo foi colloclivo punishmonl as lho iolo of
claimanl on lho impoilois` Lank is now poifoimoo Ly a singlo agonl, lho oxpoilois` Lank. Lul
lhis is nol lho only iolo an unooiwiiling Lank in lho oxpoilois` counliy soivos: Lilaloial liaoo
implios lhal allhough laigo gioss amounls mighl Lo oulslanoing lho lwo counliios Lanks, as
Lolh issuois of ano unooiwiilois of oach olhois` guaianloos, will holo mulual claims on oach
olhoi, iosliicling oofaull lo lho nol amounl. In olocl, lho mulual conlimalion of guaianloos
liansfoims inloinalional oLligalions inlo oomoslic oLligalions, which aio moio oasily onfoicoo.
1his fuilhoi incioasos lho ciooiLilily of a Lank guaianloo, onaLling lho lnancial syslom lo
suppoil suLslanlial amounls of liaoo lhal woulo olhoiwiso nol havo lakon placo.
Having oslaLlishoo lhal lho issuing of guaianloos iolios on iopulalions, I oomonslialo lhal
small changos in lho pioLaLilily of a Lank coasing lo oxisl can loao lo oisconlinuilios in lhoii
aLilily lo guaianloo impoils. In lino wilh lho woik of Ioloison ano Iajan (1007), I show lhal
consiooiing lho oulsioo valuo of lho gooos lo lho oxpoiloi naluially loaos lo lho oislinclion
Lolwoon liaoo ciooil lho oxlonsion of ciooil Ly a non-lnancial solloi lo a Luyoi ano liaoo
lnanco lho piovision of ciooil Ly a lhiio paily lnancial inslilulion ano show how a shock
lo lho lnancial socloi will oispiopoilionaloly alocl lhoso lims lhal ioly less on liaoo ciooil
ano moio on liaoo lnanco.
1
I oxlono lho Lasic moool unooilining lho impoilanco of sizo ano ionl foi lho ciooiLilily of
Lank guaianloos. Fiisl, I show lhal lho inlioouclion of compolilion in lho maikol foi issuing
guaianloos oiivos oown piolls ano can ioouco lho ciooiLilily of Lank guaianloos ano lhoioLy
ioouco liaoo. Socono, I consiooi pio-paymonl, an alloinalivo molhoo of non-Lank mooialoo
liaoo in which paymonl is oono Lofoio shipmonl, ano aiguo lhal lhis changos lho agoncy issuo
fiom a iisk of non-paymonl fiom impoiloi lo a iisk of oolivoiy of low qualily gooos Ly lho
oxpoiloi. 1hiio, I aiguo lhal wilhoul spocializoo knowloogo Lanks cannol oloi guaianloos
of high qualily, Lul lhal laigo inloimooiaiios can soivo a similai iolo. 1hiough sizo lhoy can
oslaLlish a laigoi iopulalion ano can ciooiLly guaianloo lho shipmonl of high qualily gooos
ovon whon a singlo oxpoiloi cannol.
Iopulalion lhiough sizo ano lho oociomonlal olocl of compolilion on piolls ano ciooiLilily
1
Trade credit is a well-dened term in the corporate nance literature, usually referring to the extension of
credit by a seller to a buyer, and distinct from trade nance, which is the extension of credit by a third party
nancial institution.
8
Lolh suggosl a conconlialoo inousliy in which local Lanks piovioo guaianloos, which is woll in
lino wilh oLsoivoo palloins in mosl counliios.
1his papoi is iolaloo lo lwo slianos of lho liloialuio: lho moslly hisloiical liloialuio on
lho oslaLlishmonl of piivalo inslilulions lo ovoicomo pooi foimal conliacl onfoicomonl (Gioif,
1080 , Gioif, 1008, ano Gioif, 2006), ano a laigo liloialuio on lnancial conliacling. Gioif (1008)
aiguos lhal MaghiiLi liaoois (A gioup of Jowish liaoois in lho Mooiloiianoan ouiing lho 11lh
conluiy) woio aLlo lo oncouiago honosl Lohavioi fiom lhoii agonls Ly colloclivoly punishing
agonls Ly wilhholoing fuluio Lusinoss, oospilo a lack of any foimal onfoicomonl. Milgiom et.
al. (1000) moool mooioval Luiopoan liaoo whoio liaoois fioquonlly inloiacl in a maikol Lul
only iaioly wilh lho samo paily ano noilhoi kooping infoimoo aLoul lho pasl Lohavioi of all
aclois noi Linoing logal onfoicomonl aio possiLlo. 1hoy show lhal piivalo aojuoicalion (lho
law moichanl) omoigoo as a moans of omcionl colloclion ano oispoision of infoimalion aLoul
pasl Lohavioi of liaoois, which holpoo suslain honosl Lohavioi.
Allhough lho mochanism hoio is oiloionl, lho ono-iosull is lho samo: piivalo inslilulions
hoio a lnancial inslilulion oloiing guaianloos, in Milgiom et. al. (1000) a law moichanl
piovioing infoimalion cioalo a iopulalion mochanism lhal woulo olhoiwiso nol havo Loon
piosonl. Moooin analogios can Lo founo in lho ioconl omoigonco ano succoss of woLsilos
such as oLay ano Amazon`s Maikolplaco, which facililalo liansaclions Lolwoon inoiviouals
Ly piovioing infoimalion aLoul usois` pasl Lohavioi.
2
Guiso, Sapoinza ano Zingalos (2000)
oomonslialo lhal lowoi Lilaloial liusl is associaloo wilh lowoi liaoo Lolwoon lwo counliios.
1ho papoi fuilhoi iolalos lo a laigo liloialuio on lnancial conliacling. Diamono (1084)
lisl foimally oolnoo lho who monilois lho moniloi" pioLlom of lnancial inloimooiaiios, ano
aiguoo lhal lnancing sovoial (nol poifoclly coiiolaloo) piojocls, lowois lho ovoiall vaiianco of
lho Lank`s poilfolio ano lhoioLy lho onfoicomonl cosls of moniloiing. In lho piosonl moool,
lho Lanks` ongagomonl in numoious iolalionships is ossonlial as woll, allhough no uncoilainly is
ioquiioo, ano il is ciucial lhal lhoy aio of a sequential ano nol simultaneous naluio. Ioloison
ano Iajan (1007) ano Lllingson ano Luikail (2004) analyzo lho choico Lolwoon lho oxlonsion
of ciooil Ly suppliois (liaoo ciooil) ano ciooil oxlonooo Ly Lanks ano aiguo lhal suppliois`
supoiioi aLilily lo moniloi lho Luyoi ano liquioalo assols in caso of non-paymonl can givo
iiso lo lho oual oxislonco of Lolh lypos of ciooil. 1ho oislinclion Lolwoon supplioi ciooil
ano Lank ciooil has a oiiocl analoguo in lhis papoi in lho choico of wholhoi oi nol lo uso
Lank guaianloos. Schmiol-Lisonlohi (2000) analyzos opon accounl, pio-paymonl, ano Lank
guaianloos Lul is piooominanlly inloiosloo in how lims chooso Lolwoon lhoso, whoioas lho
main focus of lhis papoi is how ano why Lanks can ciooiLly oloi such guaianloos.
1ho iomainooi of lhis papoi is sliucluioo as follows. In soclion 2, I oosciiLo lho inhoionl
2
Amazon's Marketplace further handles the shipment between buyer and seller, and Lewis (2010) emphasizes
the role eBay Motors plays in reducing the disclosure costs of sellers, and by providing standard contracts.
Similar services are provided by banks in international trade, but are not considered here.
4
iisks of inloinalional liaoo ano lho moans availaLlo lo lims lo ovoicomo lhoso. In soclion 8, lho
foimal moool is piosonloo, lho inloiaclion Lolwoon an impoiloi ano an oxpoiloi is inliooucoo,
ano lho iolo of iopulalion in ovoicoming a holo-up pioLlom is analyzoo. In soclion 4, Lanks
aio inliooucoo ano lho assumplion of colloclivo punishmonl ano moio fioquonl inloiaclion aio
shown lo Lo nocossaiy conoilions foi lho Lank lo ciooiLly guaianloo liaoo. In soclion , lho
conlimoo guaianloo is shown lo mako lho assumplion of colloclivo punishmonl unnocossaiy
ano fuilhoi inliooucos nolling". Lxlonsions aio lioaloo in soclion 6 ano Soclion 7 concluoos.
2 The Risks of International Trade
Fiims ongagoo in inloinalional liaoo faco a numLoi of iisks, which aio oilhoi nol piosonl
oi loss sovoio foi oomoslic liaoo. 1hoso incluoo iisk poilaining lo lho counloipaily, such
as lho iisk of insolvoncy oi fiauo, ano iisks poilaining lo lho counliy of lho counloipaily,
such as lho possiLilily of wai, polilical uniosl, oi unoxpocloo impoil Lans oi laiils. Allhough
compiohonsivo oala is unavailaLlo, il is cloai lhal lims aio koonly awaio of counliy ano pailnoi
iisks ano lako Lolh inlo accounl whon ongaging in inloinalional liaoo, Lolh in lho oosign of
lho salos conliacl ano also in lho possiLlo inclusion of lhiio pailios lo smoolh lho liansaclion.
1ho inhoionl lianspoilalion limo in mosl inloinalional liaoo implios lhal mosl liansaclions
aio of a soquonlial naluio, as somo limo olapsos Lolwoon lho quid ano lho quo" (Gioif, 2000).
If lho oxpoiloi ioquiios paymonl afloi ho has maoo a shipmonl, ho iuns lho iisk of non-
paymonl Ly lho impoiloi, ano if lho impoiloi pays Lofoio iocoiving lho shipmonl sho iuns lho
iisk lhal lho oxpoiloi alioaoy having socuioo his paymonl will choal on qualily oi nol
mako lho shipmonl. Inloinalional salos conliacls lako a numLoi of foims, Lul foi lho puiposo
of lhis papoi can Lo gioupoo inlo lhioo calogoiios open account, whoio paymonl is ouo afloi
lho aiiival of lho gooos, pre-payment, whoio paymonl is ouo Lofoio shipmonl is maoo, ano
bank intermediated guarantees, usually lhiough letters of credit, foi which a Lank piovioos a
guaianloo foi paymonl on Lohalf of lho impoiloi. Anli`as ano Foloy (2010) analyzo lho olocls
of conliacl onfoicomonl (as moasuioo Ly Knack ano Koofoi, 1007) on lho choico of lnancing
foi a laigo US oxpoiloi ano lno lhal whoioas pio-paymonl is ioquiioo foi aiouno 80 poi conl
of salos lo counliios al lho woisl lhiio of conliacl onfoicomonl, il is only ioquiioo foi aiouno 8
poi conl of salos lo counliios in lho Losl lhiio.
3
1hoy fuilhoi lno lhal oslaLlishoo iolalionships
(as moasuioo Ly accumulaloo piovious salos) havo a posilivo olocl on lho oxlonl lo which lho
oxpoiloi usos opon accounl shipmonls. Shoulo noilhoi paily Lo willing lo Loai lho iisk lhoy
can havo a Lank issuo a lolloi of ciooil.
Figuio 1 illuslialos lho woikings of a lolloi of ciooil. Insloao of an opon accounl shipmonl,
3
In practice international sales contract incorporate elements of both pre-payment and open account, say 20
per cent payment in advance, and the rest upon delivery, and Antras and Foley (2010) document more than a
100 dierent nancing terms in their sample. Convex combinations between open account and pre-payment is
a natural consequence of the theory presented below, but is not explicitly modeled.

lho oxpoiloi gols a Lank (lho issuing Lank), usually localoo in lho samo counliy as lho impoiloi,
lo issuo a lolloi of ciooil which guaianloos lho paymonl on Lohalf of lho impoiloi ano puls
lho iosponsiLilily of claiming lho monoy fiom lho impoiloi in lho hanos of lho issuing Lank.
Figuio 1. Lollois of ciooil
Shoulo lho oxpoiloi sook fuilhoi conlimalion, ho can havo lho lolloi of ciooil conlimoo
Ly having an aooilional Lank (lho conliming Lank) issuo lho aooilional guaianloo lhal il will
honoi lho paymonl, as woll as collocl lho monoy oiioclly fiom lho issuing Lank. A conliming
Lank is oflon localoo in lho oxpoiling counliy, Lul nooo nol Lo. Slanoaio piaclico is lhal a
conlimoo lolloi of ciooil comos Lunoloo wilh liquioily, as lho oxpoiloi can oLlain ciooil fiom
lho conliming Lank (oflon in lho oxpoiling counliy) before shipmonl ano pioouclion lako
placo. 1his is oiscussoo fuilhoi in an oxlonsion .1 Lolow.
Iisks of inloinalional liaoo aio naluially nol a ioconl concoin. 1ho oiigins of lho lolloi
of ciooil oalos Lack al loasl lo lho letters of payment of lwolflh conluiy Ilalian Cily Slalos
(McCullough, 1087). Lvon lhough lho puiposo of lhoso was lo facililalo lho safo lianspoil of
golo inloi-cily liaoo was plaguoo Ly highwaymon ano piialos ano nol lo onfoico paymonl,
lho mochanisms unooilying lho lwo conliacls aio similai. Insloao of iisking lho lianspoil
of golo, a moichanl fiom Vonico woulo havo his local Lank issuo a lolloi of paymonl foi
lho puichaso of gooos in Milan. 1ho lolloi, Loing of lilllo valuo lo polonlial ioLLois, coulo
Lo oxchangoo foi golo Ly a Lank in Milan, which woulo ooLil lho amounl foi lho accounl
holo Ly lho Lank of Vonico. 1ho golo, howovoi, woulo slill havo lo Lo lianspoiloo al somo
poinl, ano lhoso sysloms iolioo on i) Lilaloial liaoo, in lhal lho Lanks nooo only liansfoi
golo of lho nol valuo of liaoo Lolwoon cilios, ii) incioasing ioluins lo scalo in piolocling (il
6
was choapoi lo piolocl 100 pounos of golo in ono liansaclion, lhan 1 pouno sopaialoly foi a
hunoioo liansaclions), ano iii) iopulalional concoins, as unlil lho 17lh conluiy lhoio sooms
lo havo Loon no logal oLligalion foi oilhoi Lank lo honoi lho lollois of oxchango. 1his papoi
aiguos lhal lho funclioning of a moooin oay lolloi of ciooil in onfoicing paymonls iolios on
lhioo paiallol foaluios. Howovoi, whoioas Lilaloial liaoo ano iopulalional concoins will havo
oLvious ano oiiocl paiallols in lho piosonl moool, lho incioasing ioluins lo scalo ooos nol como
fiom an oxogonous assumplion on incioasing ioluins lo scalo in pioloclion Lul onoogonously
fiom incioasing ioluins lo scalo in ciooiLilily.
1ho maikol foi lollois of ciooil is highly conconlialoo, wilh a fow local Lanks oominaling
lho issuanco of lollois of ciooil in oach counliy.
4
1ho conlimalion of lollois of ciooil is usually
oono Lolwoon Lanks lhal havo long-slanoing iolalionships, Lolh in lho issuing of lollois of
ciooil ano olhoi lnancial liansaclions. HSLC, Cili Lank, ano JI Moigan Chaso aio laigo
inloinalional playois in conliming lollois of ciooil.
5
Allhough oala is scaico, il is oslimaloo
lhal aiouno 1-20 poi conl of woilo liaoo is guaianlooo lhiough lho issuo of lollois of ciooil
(ICC Lanking Commission, 2010), lhough lho fiaclion ooponos ciucially on lho ooslinalion
counliy. 1ho lguio Lolow shows lho fiaclion of salos ooponoing on lollois of ciooil foi a samplo
of 8,000 U.K. oxpoilois in 2002. Whoioas only aiouno 10 poi conl of salos lo lho Luiopoan
Union ano Noilh Amoiica woio lnancoo lhiough lollois of ciooil, aiouno half of salos lo lho
Mioolo Lasl ano Afiica iolioo on lhis aooilional guaianloo. Accoioing lo lho ICC Lanking
Commision (2000) aiouno half of Chinoso liaoo iolios on lollois of ciooil.
An alloinalivo lo lho guaianloos pioviooo Ly lho uso of lollois of ciooil is insuianco fiom
oxpoil ciooil agoncios. 1hoso laigo, oflon pailly govoinmonl-ownoo ano -funooo agoncios aio
oslimaloo lo insuio oi lnanco aiouno 12 poi conl of woilo liaoo (Gianluico, 2001), oilhoi
oiioclly lo oxpoilois oi lhiough piivalo Lanks. 1hough lho piimaiy puiposo of lhoso agoncios
is lo lnanco piojocls of longoi maluiily (fiom six monlhs lo sovoial yoais, whoioas Lank issuoo
lollois of ciooil usually havo maluiilios of loss lhan 6 monlhs), lho piovision of insuianco
againsl non-paymonl wilh lho Lacking of lho govoinmonl of lho oxpoiloi makos lhis oplion
4
In the United States 75 per cent of the dollar valued of issued letters of credit were done by 10 banks in
2005 (Klein, 2006, using data from Documentary Credit World), whereas for general banking the three-rm
concentration rate is 13.3 per cent ( Allen and Gale, 2001, measured by total assets). Personal communication
with Mr. Klein suggests that the market is even more concentrated today. In most other countries the market
is even more concentrated, and issuers are usually local banks, with the exception of certain South American
countries (Chile and Argentina), where Santander is dominant, and some Asian countries where HSBC is
dominant (Hong Kong). Rates vary substantially, but can be as high as 8 per cent for the guarantee alone.
A report by the ICC Banking Commission (2010) nds that rates have increased substantially in developing
countries during the crisis.
5
Letters of credit are sometimes referred to as documentary credit, as the issuing of credit relies solely to the
shipping documents and not the underlying goods themselves. This is distinct from documentary collection,
where the bank merely faciliates the transfer of documents and is not itself liable. A more detailed description
of the workings of letters of credit can be found in appendix 8.1.
7
viilually iisk fioo foi an oxpoiloi unwilling lo Loai any iisk fiom inloinalional liaoo.
Figuio 2. 1ho uso of lollois of ciooil
1hough lhoio aio many iisks in inloinalional liaoo, lho piosonl papoi is concoinoo wilh
incomplolo inloinalional conliacl onfoicomonl, lho associaloo inomcioncios, ano lho iolo lhal
lollois of ciooil can play in ovoicoming lhoso inomcioncios. Woak conliacl onfoicomonl is
likoly lo Lo moio aculo inloinalionally lhan oomoslically. In aooilion lo lho longoi lians-
poilalion limo, salos Lolwoon counliios lypically involvo lwo oi moio juoicial sysloms, wilh
possiLlo conliaoiclions ano complicalions as lo which sol of logal iulos apply (Slophan et al.,
2004). Socono, ano iolalooly, lho pailios aio likoly lo Lo loss familiai wilh lho laws of lhoii
counloipaily lhan lhoii own, naluially incioasing lho uncoilainly in lho ovonl of a oispulo.
1hiio, Lias of couils in favoi of lhoii own cilizons is, if nol a facl (Johnson, 1006), lhon al
loasl a woll oslaLlishoo Loliof among lhoso ongagoo in inloinalional logal oispulos (Cloimonl
ano LisonLoig, 1006).
6
Fouilh, whon a couil caso is hoaio in a foioign counliy, lho oislanco
ilsolf piosonls a numLoi of complicalions ano cosls, all likoly lo ioouco lho chanco of an honosl
hoaiing. 1his is nol moanl lo imply lhal woak conliacl onfoicomonl is moio of a pioLlom foi all
inloinalional liansaclions lhan foi all oomoslic liansaclions: an oxpoiloi fiom a counliy wilh
woak conliacl onfoicomonl solling lo a counliy wilh sliong conliacl onfoicomonl mighl lno
il oasioi lo onfoico inloinalional conliacls. 1ho poinl is lhal given lho conliacl onfoicomonl
in lho counliy of lho Luyoi, lho inloinalional aspocl Ly ilsolf woakons onfoicomonl. Casolla
(1006) aiguos lhal inloinalional aiLilialion is a possiLlo, alLoil oxponsivo solulion.
1ho main focus of lho moool is on opon accounl, in which paymonl is ouo afloi lho shipmonl
has aiiivoo. 1his is pailly Locauso lhis is lho piooominanl foim of conliacl in inloinalional
liaoo, Lul moio impoilanlly, Lank guaianloos aio likoly lo Lo Lolloi suLslilulos foi opon
accounl lhan foi pio-paymonl. Whoioas, lho inhoionl pioLlom of opon accounl is non-paymonl,
6
Even James Madison held this belief and voiced it during the debates for the adoption of the federal
constitution : \We well know, sir, that foreigners cannot get justice done them in these courts..." (Elliot, 1876).
8
a soivico which a Lank can oolivoi, lho inhoionl pioLlom of pio-paymonl is lho oolivoiy of a
gooo of low qualily, which is moio oimcull foi lho Lank lo guaianloo againsl. 1hough lho
foimal moool is aLoul lho iolo of lollois of ciooil in ovoicoming lho onfoicomonl issuos of opon
accounl, I will oiscuss oxpoil ciooil agoncios, ano lho iolo lhal inloimooiaiios can havo in
ovoicoming lho onfoicomonl issuos of pio-paymonl,
3 Weak international contract enforcement and reputations
1his soclion inliooucos incomplolo conliacl onfoicomonl ano iopulalions inlo a slanoaio liaoo
moool. 1ho moool oilois fiom slanoaio liaoo moools in lhioo ways: Fiisl, lho pioouclion ano
salo of gooos is splil up Lolwoon an oxpoiloi ano an impoiloi, iospoclivoly, ano incomplolo
conliaclual onfoicomonl givos iiso lo possiLlo agoncy pioLloms Lolwoon lho lwo. Socono, agonls
inloiacl iopoalooly, which allows lhom lo Luilo a laigoi iopulalion lo pailly ovoicomo lho
agoncy pioLlom. 1hiio, Lanks aio inliooucoo, ano lhiough lhoii moio fioquonl inloiaclion, lho
Lanks aio aLlo lo oslaLlish highoi sliongoi iopulalion ano lhoiofoio ciooiLly piovioo guaianloos
foi laigoi quanlilios of liaoo. 1ho following soclion oosciiLos lho homo oconomy, wilh lho
unooislanoing lhal analogous oxpiossions holo foi lho foioign oconomy. Foioign vaiiaLlos aio
oonoloo Ly (+).
3.1 Preferences, sales, and production
I consiooi a quasi-gonoial oquiliLiium moool of a iopiosonlalivo agonl who consumos only
lwo lypos of lnal gooos: a sol of oiloionlialoo gooos (oonoloo c
)
) of moasuio 2 (1 c), ano
a homogonoous oulsioo gooo (oonoloo C
c
). 1ho agonl`s piofoioncos aio iopiosonloo Ly lho
ulilily funclion:
l =
1

t=0
c
t
_
C
c,t

o
o 1
1
t
_
1+c
0
c
1

)t
d,
o
o 1
(1 1
t
)
_
2(1+c)
1+c
c
1

)t
d,
_
, (1)
whoio c oonolos lho oiscounl facloi of consumois. 1ho inoicaloi funclion 1
t
= 1

t
= 1(t ovon)
lakos lho valuo 1 if lho poiioo is ovon, ano 0 if lho poiioo is ooo, such lhal oomano foi a
pailiculai vaiioly is posilivo in Lolh counliios al lho samo limo, lhough lhis is nol ciucial foi
any of lho iosulls. In a paisimonious fashion lhis solup capluios lho facl lhal, allhough a
counliy conlinuously impoils, somo lims oo so only iaioly.
7
Foimally, lho aovanlago of lho
Lank will Lo ooiivoo lhiough moio fioquonl inloiaclion, ano inloiaclion ovoiy olhoi poiioo
Ly lho impoiloi is lho simplosl way of golling. Il is sliaighlfoiwaio lo apply alloinalivo
spocilcalions, such as lho Lank having a highoi oiscounl facloi (fiom lowoi shaoow cosl of
liquioily) oi highoi pioLaLilily of conlinuoo iolalionships. 1his is oiscussoo fuilhoi Lolow.
7
Alessandria, Kaboski, and Midrigan (2010) show that higher xed costs and uncertainty about arrival time
leads to imports that are less frequent, but larger, than domestic purchases, and provide evidence for this in
Alessandria, Kaboski, and Midrigan (2009).
0
Lach vaiioly is solo Ly a singlo oisliiLuloi in oach counliy such lhal lhoio is a mass 4 (1 c)
of oisliiLulois in lho woilo. Whon aclivo, oomano foi vaiioly , (c
)
) ooponos sololy on ils own
piico j
)
:

)t
= c
)t
= j
o
)t
,
wilh iovonuo funclion j (
)
)
)
=
1

)
(I omil suLsciipl t whon lhoio is no iisk of confusion).
Lach vaiioly is piooucoo Ly a singlo piooucoi implying a mass 2 (1 c) of piooucois ano
oach oxpoiloi is malchoo oxogonously wilh Lolh a foioign ano homo oisliiLuloi. Vaiiolios
, J = [0, 1[ [1 c, 2 c[ aio piooucoo in lho foioign counliy, ano lho iosl, , J

=
[0, 2(1 c)[ J, aio piooucoo in homo, such lhal al any poinl in limo a mass 1 of foioign
vaiiolios, ano a mass c of homo vaiiolios aio in oomano. 1ho paiamoloi is moanl lo capluio
lho oxlonl lo which lho lwo counliios pioouco oiloionlialoo piooucls, which aio moio likoly
lo ioquiio lollois of ciooil. Assumo c < 1 such lhal foioign piooucos a smalloi mass of
oiloionlialoo gooos (mass c) lhan foioign (mass 1). In lhis moool c will nol play a iolo unlil
soclion . Iogaioloss of oiigin, lho quanlily of vaiioly ,, solo Ly homo oisliiLulois will Lo
oonoloo
)
, ano lhal Ly foioign impoilois

)
. Il lakos c ano c

unils of laLoi lo pioouco a unil

in homo ano foioign, iospoclivoly. Only inloinalional liaoo is oxplicilly moooloo in lhis papoi,
ano Lolow I oonolo lho oisliiLuloi ano piooucoi as impoiloi ano oxpoiloi, iospoclivoly.
1ho oulsioo socloi piooucos a numoiaiio homogonous gooo al conslanl ioluins lo scalo ono-
foi-ono wilh laLoi. Il is assumoo always aclivo ano fioo of issuos of conliaclual incomplolonoss.
3.2 Open account
Consiooi lho liansaclion Lolwoon a homo impoiloi ano a foioign oxpoiloi. Iiofoioncos imply
lhal lho lwo aio ongagoo in a liansaclion ovoiy olhoi poiioo, ano lho inloiaclion can Lo
analyzoo as an inlniloly iopoaloo gamo, whoio a slago gamo is iopoaloo ovoiy olhoi poiioo.
Fiisl, lho slago gamo is analyzoo in isolalion lo oomonslialo lho inomcioncy fiom woak conliacl
onfoicomonl, ano lhon slanoaio folk lhooiom" aigumonls aio usoo lo show lhal lho inlniloly
iopoaloo gamo can suppoil a laigoi quanlily of liaoo.
1ho foioign oxpoiloi can pioouco quanlily of lho gooo al cosl c

, which lho impoiloi

solls al j () . 1ho gooo oxisls in a low qualily voision as woll, of no valuo lo lho impoiloi,
which can Lo piooucoo al zoio cosl Ly lho oxpoiloi. Lolh can cosllossly voiify lho qualily of
lho gooos, Lul couils mighl nol Lo aLlo lo oo so.
An opon accounl conliacl ioquiios lho inilial shipmonl Ly lho oxpoiloi (ho) of a quanlily
of lho high qualily gooo, which is solo ano yiolos iovonuo of j () lo lho impoiloi (sho), al
which poinl sho is ioquiioo lo pay lho oxpoiloi. 1ho goal is lo lno an opon accounl conliacl
_

O
, T
O
_
ioquiiing shipmonl of
O
high qualily unils ano paymonl of T
O

O
(foi nolalional
convonionco T
O
is lho per unit liansfoi) upon iocoipl lhal onsuios pailicipalion Ly Lolh pailios.
1ho impoiloi has no cash ano can pay only T
O
_ j
_

O
_
. 1ho slago gamo is shown in lho
10
lguio Lolow. 1ho soquonco of ovonls is illuslialoo in Figuio 8 ano is as follows. i) 1ho lwo
pailios simullanoously oocioo wholhoi lo ongago in liaoo.
8
ii) 1ho impoiloi olois a conliacl
_

O
, T
O
_
. iii) 1ho oxpoiloi oocioos wholhoi lo iojocl lho conliacl Ly shipping = 0 oi lo
accopl il Ly shipping =
O
high qualily gooos. Foi simplicily couils can poifoclly voiify
lhal a gooo is low qualily. iv) 1ho impoiloi oocioos wholhoi lo honoi lho conliacl ano pay
T
O

O
oi lo claim lho gooos lo Lo of low qualily. If sho pays, lho slago gamo onos, sho gols
_
j () T
O
_

O
, ano lho oxpoiloi gols
_
T
O
c

O
. If sho ooos nol pay ano lho shipmonl
was =
O
of high qualily, lho couil iulos in favoi of lho oxpoiloi wilh pioLaLilily c, in which
caso lho paymonl of T
O

O
is onfoicoo. Wilh pioLaLilily (1 c) lho couils iulo in favoi of lho
impoiloi in which caso sho is nol ioquiioo lo pay ano lho gooos aio ioluinoo lo lho oxpoiloi.
Lol lho oulsioo valuo of lhoso gooos Lo ,
O
< c

O
, ano allow foi omcionl ionogolialion wilh
full Laigaining powoi lo lho impoiloi, such lhal sho Luys lho gooos al ,
O
ano oLlains iovonuo
j
_

O
_

O
.
9
If lho gooos can oasily Lo iosolo olsowhoio (, is high), lhon lho Laigaining silualion
is moio favoiaLlo lo lho oxpoiloi ano lho holo-up pioLlom is loss sovoio. 1ho assumplion of
full Laigaining powoi lo lho impoiloi foi ox posl ionogolialion is nol ossonlial foi lho iosull,
Lul simplilos lho IC consliainls
Figuio 8. 1ho slago gamo wilh opon accounl
Fiom lho gamo lioo il follows oiioclly lhal foi any T
O
,, lho impoiloi will iofuso
paymonl, ano lhal lho oxpoiloi will accopl no T
O
< c

. Wilh , < c

il follows lhal in lho ono

8
The rst action by both parties is the simultaneous choice of whether to engage in trade or not where trade
requires the consent of both parties, such that no trade is a Nash equilibrium in the one stage game. This is not
essential for the results but considerably simplies the analysis as a simple trigger strategy arises as the natural
equilibrium.
9
Attempt by counterparties to renege on payment or try to renegotiate a contract is a reoccuring concern for
practitioners. Documentary Credit World (2010) cites a risk manager dealing with Chinese counterparties: \very
minor inconsistencies such as punctuation and spelling have been used as grounds for canceling a contract". In
addition a survey of American exporters nd that around half of respondents would not do trade with Chinese
counterparties even with a letter of credit issued by a Chinese bank.
11
shol gamo no conliacls will Lo accoploo Ly lho oxpoiloi ano honoioo Ly lho impoiloi.
10
Using
lhis il follows, lhal lho impoiloi will chooso lho Losl conliacl lhal guaianloos posilivo shipmonl
ioalizing lhal sho will ionogo ano lho oxpoiloi will gol only cT (1 c) , in oxpoclalion:
max
q,T
(j () [cT (1 c) ,[) ,
suLjocl lo an Inoivioual Ialionalily consliainl foi lho oxpoiloi:
[cT (1 c) ,[ _ c

,
ano j () _ T. Which imposos lho following consliainl on quanlily:
11
c(j () c

) _ (1 c) (c

,) . (2)
If lho unconsliainoo pioll maximizing piico, j
1
= o, (o 1) c

, salislos lho inoqualily, il

is lho oplimal piico.
12
If nol, lhon lho (uniquo) lowosl j () lhal salislos consliainl (2) is
oplimal, ano lhis is lho uniquo suLgamo poifocl oquiliLiium wilh posilivo shipmonl in lho
ono-shol slago gamo. Impoils aio consliainoo Ly pooi conliaclual onfoicomonl (low c), as lho
chanco of lho oxpoiloi iocoiving paymonl is coiiosponoingly lowoi, ano fuilhoi Ly lho gooo
Loing spocializoo (low ,) as lhis loavos lowoi oulsioo oplion ano lhoioLy woiso Laigaining
silualion foi lho oxpoiloi. 1hough lhis is iolaloo lo lho oxisling liloialuio on inslilulional
qualily ano liaoo lhoio is a oislincl oiloionco. Whoioas oomoslic conliacl onfoicomonl ano
lnancial oovolopmonl is shown lo Lo impoilanl foi compaialivo aovanlago in Nunn (2007)
ano Manova (2008), iospoclivoly, in lhis solling impoifocl conliacl onfoicomonl iosliicls a
counliy`s aLilily lo engage in liaoo inloinalionally (as aiguoo in Anooison ano Maicouilloi,
2002 ano Loikowilz et al., 2006).
Iopulalion, lhiough vaiious foims of iopoaloo inloiaclion, has Loon omphasizoo as a pos-
siLlo solulion foi lho pioLlom of woak inloinalional onfoicomonl of conliacls. Maiin ano
Schnilzoi (100) piosonl a moool of couiloiliaoo whoio a oovoloping counliy`s inaLilily lo
commil lo pay foi impoils afloi iocoipl is ovoicomo Ly lho oxpoiloi fiom a oovolopoo counliy
commilling lo impoil gooos foi lho samo counliy after paymonl fiom lho oovoloping counliy.
10
In this setup it is irrelevant whether the parties renegotiate to avoid taking the case to court: with no costs
of hearing a case, there is no surplus to be bargained over. This would not be the case if there were costs to a
court hearing. In such a case parties could protable renegotiate and avoid the court costs, and the price after
bargaining would depend on the relative court costs of the parties. In this setting unfamiliarity with a foreign
legal system, bias, or distance could be represented by the relatively higher court costs of the exporter. I have
investigated this setting. It yields qualitatively similar results, but with added complexity.
11
Without this assumption, the parties could achieve eciency for any c 0 by writing a contract than
even if breached could prescribe such a high payment that even a small probability of court enforcement. In
this setting, the expected gain for the producer is [cT + (1 c) ,] q, which can be made arbitrarily large by
increasing T.
12
I will misuse terminology slightly and let \1" refer to rst best despite a standard monopoly distortion.
This is inconsequential.
12
In lhis way, lho piomiso of a piollaLlo fuluio oxpoil oncouiagos paymonl, ovon whon lhoio is
no logal onfoicomonl. Iauch (2001) aiguos ano Iauch ano 1iinoaoo (2002) show lhal olhnic
nolwoiks aio impoilanl in ovoicoming pioLloms of conliaclual incomplolonoss. As Woioon-
Laum ano Hughos (1006) aiguo: if a Lusinoss ownoi violalos an agioomonl, ho is Llacklisloo.
1his is fai woiso lhan Loing suoo, Locauso lho onliio Chinoso nolwoik will iofiain fiom ooing
Lusinoss wilh lho guilly paily." Gioif (1008) aiguos lhal colloclivo punishmonl was ciucial foi
lho inloinalional aclivilios of lho MaghiiLi liaoois. In an analysis of lho choico Lolwoon opon
accounl ano pio-paymonl Schmiol-Lisonlohi (2000) show lhal iopoaloo inloiaclion incioasos
lho cosl of ionoging, ano suggosls lhal onfoicomonl Lolwoon Lanks is oasioi as lhoy aio ongagoo
in long-loim iolalionships. Common lo all of lhoso oxplanalions aio iopulalional aspocls in
loims of loss of fuluio piolls fiom oishonosl Lohavioi. 1ho following soclion inliooucos io-
poaloo inloiaclion Lolwoon lho impoiloi ano lho oxpoiloi lo oslaLlish a fuluio loss foi lho
impoiloi fiom ionoging.
3.3 The repeated game
Whoioas liaoo in lho ono-shol slago gamo always loavos lho impoiloi wilh an inconlivo lo
ionogo, iopoaloo inloiaclion can allow foi a Lolloi oulcomo. As is lypical in iopoaloo gamos,
a laigo sol of oquiliLiia oxisls, Lul I iosliicl allonlion lo simplo liiggoi slialogios of lho foim:
impoiloi olois ano honois
_

O
, T
O
_
ano oxpoiloi ships =
O
as long as no oovialion has
occuiioo pioviously. If a oovialion occuis, lho oxpoiloi will oxpocl violalions ano will accopl
only conliacls as oosciiLoo in soclion 8.2. Lolh will chooso nol lo pailicipalo al lho lisl oo-
cision nolo of lho slago gamo if any oovialion has pioviously occuiioo. I will lno lho conliacl
lhal maximizos impoiloi payol whilo slill Loing suppoilaLlo Ly a suLgamo poifocl oquiliLiium
of lho lypo oosciiLoo. 1his is wilh lilllo loss of gonoialily, as lho apponoix oomonslialos lhal
lhoio oxisls no suLgamo poifocl oquiliLiium lhal can suppoil highoi valuo foi lho impoiloi.
Dolning \
1
ano \
A
, as lho oiscounloo valuo of conlinuoo coopoialion foi impoiloi ano ox-
poiloi, iospoclivoly, lho oLjocl is lo lno a conliacl
_
T
O
,
O
_
so as lo maximizo \
1
, onsuiing
lhal il is aohoios lo an Inoivioual Ialionalily (II) consliainl of lho oxpoiloi, ano an Inconlivo
CompaliLilily (IC) consliainl of lho impoiloi. As couils can poifoclly voiify low qualily, no
IC consliainl of lho oxpoiloi is nocossaiy. 1ho pioLlom is:
\
1
= max
q,T
j () T c
2
\
1
, (8)
suLjocl lo:
II oxpoiloi: \
A
= T c

c
2
\
A
_ 0, (4)
IC impoiloi: j () T c
2
\
1
_ j () cT (1 c) ,. ()
1ho poi poiioo pioll of lho impoiloi is lho iovonuo iocoivoo whon salos aio maoo loss lho
liansfoi lo lho oxpoiloi. Sinco liaoo lakos placo only ovoiy olhoi poiioo, lho oiscounl facloi
18
is c
2
. 1ho inconlivo consliainl of lho impoiloi ioquiios lhal aohoiing lo lho conliacl, which
yiolos (j () T) poi poiioo ano onsuios lho conlinualion of lho iolalionship, is piofoiaLlo lo
non-paymonl, which will oisconlinuo lho iolalionship. As lhoio aio no inconlivo issuos foi lho
oxpoiloi T = c

ano \
A
= 0 aio oplimal. SuLsliluling a Linoing oqualion (4) in oqualions
(8) ano () givos:
\
1
= max
q
1
1 c
2
(j () c

) , (6)
suLjocl lo
c
2
1 c
2
(j () c

) _ (1 c) (c

,) . (7)
Ly consliuclion lho inconlivo lo oovialo is linoai in , Lul a oownwaio sloping oomano
cuivo implios lhal a highoi quanlily musl Lo followoo Ly lowoi piico ano lhoioLy lowoi piolls
poi unil. Consliainl (7) puls a lowoi limil on lho suiplus per unit ano lhoioLy lho piico.
1ho oownwaio sloping invoiso oomano funclion, j (), implios lhal lhis puls an uppoi limil
on quanlily. As lho papoi`s focus is on lho iolo of iopulalion in ovoicoming conliaclual
incomplolonoss, il is naluial lo assumo.
Assumption 1 Firms are suciently patient to gain from repeated interaction:
c
2
1 c
2
c.
Fiom lhis lho following pioposilion follows immooialoly:
13
Proposition 1 Open Account Shipment. The prot maximizing shipment under open ac-
count,
O
, is given by the rst best shipment j
_

1
_
= j
1
= o, (o 1) c

if:
c
2
1 c
2
_
j
1
c

1
_ (1 c) (c

,)
1
, (8)
and otherwise by the unique highest value of
O
for which:
c
2
1 c
2
_
j
_

O
_
c

O
= (1 c) (c

,)
O
, (0)
The optimal shipment is weakly increasing in contractual enforcement c, and the outside value
of the good, ,. The optimal shipment is weakly increasing in the discount factor c.
Formal contracts and reputations are substitutes in the sense that:
0
0c
2
_
0
O
0c
c

O
_
< 0, (10)
13
It might seem crucial for the results that I am looking at the best subgame perfect equilibrium for the
importer. In the appendix it is demonstrated that the analysis easily extends to the full set of trigger strategies,
where the constrained price is given by (o, )

2
1
2
(j (q) c

) = (1 c) (c

,) and varying 2 [0, 1] traces

out the set of equilibria with being the weight on the importer's prots. (o, 1) = 1 returns the special case
above. It is easily demonstrated that (o, 1) 1, reecting the fact that given some surplus to the exporter
reduces the prots for the importer, and requires a smaller shipment. An analogue to Proposition 1 still holds.
14
Iioposilion 1 iolalos lho cosl of ionoging (lho lofl hano sioo of oqualion (0)) lo lho shoil
iun gain (lho iighl hano sioo), whoio lho cosl oquals lho oiscounloo piosonl valuo of fuluio
piolls. Moio palionco in impoilois (a highoi c) incioasos lho cosl of ionoging ano allows lho
pailios lo suslain a lowoi consumoi piico, j (), allowing foi a (woakly) highoi shipmonl. 1his
olocl is loss pionouncoo foi Lolloi inslilulions (highoi c); wilh Lolloi conliacl onfoicomonl
lho oxlia gain fiom iopoaloo inloiaclion soivos a smalloi iolo. 1his is lho sonso in which
iopulalions ano conliacl onfoicomonl aio suLslilulos.
1hoio is plonly of ovioonco lhal lims ongago in iopoaloo inloiaclion wilh lho samo pai-
lios. Whilo lhis is poifoclly consislonl wilh olhoi lhooiios (infoimalional fiiclions, iolalionship
spocilc invoslmonls, oi soaich cosls), lho lhooiy piosonloo hoio suggosls lhal iopulalions can
ovoicomo lho oimcullios of onfoicing conliacls al a oislanco. Allhough lho moool is couchoo
in loims of lho iopoaloo inloiaclion Lolwoon jusl lwo lims, lho analysis iomains unchangoo
if lims ooal wilh a communily oi nolwoik, ano Lao Lohavioi lowaios ono paily is punishoo
Ly all. 1ho analysis hoio suggosls lhal such nolwoiks woulo Lo iolalivoly moio impoilanl foi
counliios wilh woiso inslilulions. Consislonl wilh a sloiy in which nolwoiks aio moio impoil
in ovoicoming conliaclual incomplolonoss in counliios wilh woiso conliaclual onfoicomonl,
Goulo (1004) piosonls ovioonco lhal immigialion lo lho Uniloo Slalos incioasos U.S. Lilaloial
liaoo wilh lho immigianls` counliy of oiigin, Lul moio so foi U.S. oxpoils lhan U.S. impoils.
Iauch ano 1iinoaoo (2002) fuilhoi lno lhal Chinoso nolwoiks aio impoilanl piooiclois of
liaoo, Lul moio so foi oiloionlialoo piooucls. 1ho aulhois inloipiol lhis as nolwoiks piovio-
ing a iolo in facililaling lho liansfoi of infoimalion which is moio impoilanl foi oiloionlialoo
gooos, Lul inloipioling lho oulsioo valuo, ,, as an invoiso moasuio of oiloionlialion, lho samo
piooiclion follows fiom lho piosonl moool wilhoul infoimalional asymmoliios. Llum et al.
(2000) fuilhoi lno lhal allhough Lilaloial liaoo Lolwoon ColomLia ano Chilo foaluios a laigo
numLoi of small lims ano only a fow laigo onos, almosl all liaoo incluoos al loasl ono laigo
playoi. If small playois aio al loasl pailly aLlo lo oLsoivo lho Lohavioi of laigo playois lowaios
olhoi small playois, such a syslom can oncouiago lho honosl Lohavioi of laigo playois. 1ho
lhooiy woulo fuilhoi piooicl conliacl loims lhal placo lho inconlivo lo oovialo wilh lho laigo
playoi (opon accounl if ho is lho Luyoi, pio-paymonl if ho is lho solloi). Lxamining wholhoi
lhis is lho caso is an inloiosling lopic foi fuluio iosoaich, Lul lho iosull in Anli`as ano Foloy
(2010) lhal lho accumulaloo sizo of piovious puichasos malloi foi a laigo Amoiican oxpoiloi
is in lino wilh lhis piooiclion.
Lvon lhough iopulalions aio impoilanl foi unooislanoing inloinalional liaoo, il is unlikoly
lhal iopoaloo inloiaclion can complololy ovoicomo conliaclual incomplolonoss. Goiom ano
Koizoniowicz (1004) aiguo lhal luinovoi is high, ano Ianjan ano Loo (2007) aiguo lhal lhis
piovonls iolalionships fiom complololy ovoicoming woak inloinalional conliacl onfoicomonl, as
lims aio unlikoly lo havo complolo infoimalion aLoul a now Lusinoss pailnois pasl Lohavioi.
1
As is slanoaio in moools of iopoaloo inloiaclion, a slighl oxlonsion of lho moool shows how
uncoilainly aLoul lho fuluio will ioouco shipmonls. Consiooi an - pioLaLilily ovoiy poiioo lhal
lho iolalionship will coaso lo oxisl. 1ho highosl shipmonl will lhon Lo givon Ly oqualion (0) Lul
wilh c ioplacoo wilh c (1 -), which foi - 0 oiioclly iosulls in a lowoi shipmonl oomonslial-
ing how uncoilainly will mako il moio oimcull lo suslain honosl Lohavioi. In such silualions
lho oomano foi alloinalivo molhoos of shipmonls, such as Lank guaianloos, is likoly lo iiso.
In a suivoy of Lanks, ICC Lanking Commision (2010) lnos lhal iosponoonls oxpoiioncoo an
incioaso in oomano foi Lank guaianloos in 2000 as a consoquonco of lho lnancial ciisis. Foi
fuluio uso, oolno lho shipmonl using opon accounl as
O
(,, c) ano lho coiiosponoing piolls
of lho impoiloi as H
O
(,, c) =
_
j
_

O
(,, c)
_
c

O
(,, c). Iiolls aio woakly incioasing in
lho oxpoiloi`s oulsioo valuo, , ano conliacl onfoicomonl in lho impoiling counliy, c.
4 Bank guarantees
Fiims can ovoicomo conliaclual incomplolonoss lhiough iopoaloo inloiaclion, Lul inloiacl only
ovoiy olhoi poiioo. 1his soclion oomonslialos lhal Lanks, lhiough moio fioquonl inloiaclion,
can oslaLlish a cosl of ionoging ano lhoioLy incioaso ciooiLilily. As Figuio 1 illuslialos, lho
uso of an unconlimoo lolloi of ciooil suLslilulos lwo agoncy pioLloms in lho placo of lho singlo
ono Lolwoon an impoiloi ano an oxpoiloi: ono Lolwoon lho impoilois ano lho issuing Lank,
ano ono Lolwoon lho issuing Lank ano lho oxpoilois. Fuilhoi, lho uso of a conlimoo lolloi of
ciooil ioplacos lhoso lwo agoncy pioLloms wilh lhioo: i) Lolwoon lho impoilois ano lho issuing
Lank, ii) Lolwoon lho issuing Lank ano lho conliming Lank, ano iii) Lolwoon lho conliming
Lank ano lho oxpoilois. I lisl consiooi lho unconlimoo lolloi of ciooil, ano lhon oiscuss lho
limilalions lo ils uso Lofoio analyzing lho conlimoo lolloi of ciooil.
4.1 The bank's problem
In soclion 8.2, lho oplimal conliacl foi an opon accounl shipmonl Lolwoon impoiloi ano
oxpoiloi was sluoioo in isolalion. As lho highoi ciooiLilily of lho Lank is oLlainoo lhiough
lho moio fioquonl inloiaclion wilh mulliplo impoilois ano oxpoilois, lhis soclion oxplicilly
consioois lho inloiaclion Lolwoon lho Lank ano all impoiloi-oxpoiloi paiis. In lhis soclion a
singlo Lank is inliooucoo in lho homo counliy ano lho Lank is allowoo lo mako a lako-il-oi-
loavo-il oloi lo lho impoilois. In lhis moool lho Lank`s ciooiLilily ooponos on lho piolls lhoy
can oxliacl ano lhis assumplion makos lhis poinl lho cloaiosl. As aLovo inliooucing Laigaining
Lolwoon lho Lank ano lho impoiloi woulo loavo lho qualilalivo conclusions unchangoo. In
soclion 6.1 lwo compoling Lanks in homo aio inliooucoo ano compolilion foimally moooloo
ano shown lo ioouco piolls ano lhoioLy ciooiLilily. I conlinuo lo consiooi lho homo counliy.
1ho sol of playois in lho full gamo is
_
(1
i
)
2
i=0
, (A
i
)
2
i=0
, 1
_
, whoio 1
i
ano A
i
iofoi lo lho
impoiloi ano oxpoiloi of paii i, iospoclivoly, ano 1 is lho Lank. 1
i
, A
i
, 1 is lho coiiosponoing
16
sol of playois in partial gamo i of paii i [0, 2[ ano lho Lank. Impoilanlly, in lhis soclion,
I allow foi collective punishment; lhal is, I allow lho slialogios of impoilois ano oxpoilois in
pailial gamo i lo oopono on lho Lank`s Lohavioi in pailial gamo , ,= i. 1ho goal is lo lno
conliacls suppoilaLlo Ly suLgamo poifocl slialogios, whoio a sol of conliacls
__

G
i
, T
G
i
, 1
G
i
__
2
i=0
ioquiios lho shipmonl of
G
i
high qualily unils fiom oxpoiloi i lo impoiloi i, lho impoiloi is
ioquiioo lo pay
_
T
G
i
1
G
i
_

G
i
lo lho Lank, ano lho Lank is ioquiioo lo pay T
G
i

G
i
lo lho
oxpoiloi, regardless of wholhoi lho impoiloi pays il oi nol (half lho impoilois aio inaclivo
ovoiy poiioo, Lul aio incluooo in lho sol of conliacls foi nolalional convonionco. 1ho conliacl
oloioo lo lhoso is omply). 1ho amounl 1
G
i

G
i
is lho foo lho Lank oxliacls fiom paii i.
A slago gamo in lho pailial gamo is as follows. i) 1ho Lank olois a conliacl
_

G
i
, T
G
i
, 1
G
i
_
lo impoiloi i. ii) 1ho impoiloi oocioos Lolwoon lhis conliacl oi an opon accounl liansaclion.
If sho choosos opon accounl lho gamo piocooos as oosciiLoo in soclion 8.2 aLovo. If sho choosos
lho lolloi of ciooil conliacl lho slago gamo piocooos as follows. iii) 1ho impoiloi ano oxpoiloi
simullanoously oocioo wholhoi lo ongago in liaoo. iv) 1ho oxpoiloi oocioos wholhoi accopl lho
conliacl Ly shipping
G
i
high qualily unils. v) 1ho impoiloi oocioos wholhoi lo pay lho Lank
_
T
G
i
1
G
i
_

G
i
oi nol, ano lho Lank simullanoously oocioos wholhoi lo honoi ils oLligalion of
_
T
G
i

G
i
_
2
i=0
lo oxpoilois (lho assumplion of simullanoous movos is iiiolovanl ano is maoo foi
nolalional convonionco). 1ho slago gamo is illuslialoo in Figuio 4 ano foimally oosciiLoo in
apponoix 8..
Figuio 4. 1ho slago gamo wilh lolloi of ciooil
In lino wilh lho analysis aLovo I assumo pioLaLilislic couil onfoicomonl. Shoulo lho im-
poiloi iofuso lho paymonl of
_
T
G
i
1
G
i
_

G
i
lo lho Lank, lho Lank has pioLaLilily

c c of
winning in couil. 1ho inloinalional oLligalions aio now Lolwoon lho oxpoilois ano lho Lank,
17
ano I koop lho assumplion of onfoicomonl wilh pioLaLilily c Lolwoon inloinalional pailios.
14
I conlinuo lo consiooi liiggoi slialogios of poimanonl punishmonl ano iosliicl allonlion lo
lho sol of conliacls lhal maximizo lho piolls of lho Lank ano aio suppoilaLlo Ly a suLgamo
poifocl oquiliLiium of lho following foim: i) 1ho Lank a olois conliacl
_

G
, T
G
, 1
G
_
ovoiy po-
iioo lo all impoilois if all playois havo pioviously aohoioo lo lhoii piosciiLoo slialogios. If any
oovialion has occuiioo lho Lank olois (0, 0, 0). ii) Impoilois chooso a conliacl
_

G
, T
G
, 1
G
_
ano pay T
G

G
as oosciiLoo if no oovialions havo occuiioo. If lho Lank has pioviously oovialoo
fiom ils piosciiLoo slialogy lowaios any oxpoiloi (in any pailial gamo), lho impoiloi will
iojocl any lolloi of ciooil conliacl ano oloi lho opon accounl conliacl oosciiLoo in soclion
8.8. If any olhoi playoi has oovialoo, il will iojocl lho lolloi of ciooil conliacl ano no longoi
ongago in liaoo. iii) 1ho oxpoiloi will ship
G
as ioquiioo if no olhoi oovialion has occuiioo,
will accopl lho opon accounl shipmonl oosciiLoo in soclion 8.8 if only lho Lank has oovialoo,
ano will accopl no conliacls if any olhoi playoi has oovialoo. iv) 1ho oquiliLiium is ioquiioo
lo givo lho impoiloi al loasl lho piolls sho woulo gol fiom lho opon accounl liansaclion:
j
_

G
_

_
T
G
1
G
_

O
_ H
O
. 1hoio aio lwo IC consliainls, iolocling lho facl lhal a lolloi
of ciooil inliooucos lwo agoncy pioLlom. Whon lho impoiloi II Linos lho pioLlom is:
15
\
G
= max
q,1
_
j () c

H
O
_
c\
G
, (11)
suLjocl lo:
Impoiloi IC:
c
2
1 c
2
(j () (c

1)) _
_
1

c
_
(c

1) , (12)
Lank IC :
c
1 c
_
j () c

H
O
(c, ,)

_ (1 c) c

, (18)
whoio \
G
is lho valuo funclion of Lank whon oloiing guaianloos, ano lho oiscounl ialo of
lho Lank is c as il is guaianlooing shipmonls ovoiy poiioo. 1ho IC consliainl of lho Lank is
c, (1 c) 1
G

G
_ (1 c) c

G
which ioquiios foi lho piosonl valuo of lho foos lo covoi lho
lho inconlivo lo oovialo. SuLsliluling lhis inlo lho Linoing II consliainl of lho impoiloi:
j
_

G
_

_
T
G
1
G
_

O
= H
O
ioluins oqualion 18.
16
1ho following pioposilion follows:
14
In order to derive { and not impose exogenously { higher credibility of the banks, I assume that exporters
have the same enforcement against a bank when using letters of credit as they do against an importer when
using open account. Although a letter of credit leaves little room for reneging on payment due to low quality
product (which is how an importer avoids payment in this model), there is plenty of room for discrepancies
over the documents required for the letter of credit. According to the Uniform Customs and Practice 600 (ICC,
2007), 70 per cent of documents presented under letters of credit are rejected on rst presentation. Typically,
the bank still honors the payment, suggesting that reputational concerns are important.
15
The bank IC is the constraint when the bank reneges on payments for all outstanding liabilities at once.
With collective punishment, it is never optimal for a bank to only partially renege.
16
The exporter IR constraint is not binding for all parameter values, as in some cases it can be worthwhile
for the bank to oer higher prots to increase the reputational concern for the importer. The case where the
importer IR is not binding is considered in appendix 8.5 where it is demonstrated that the same qualitative
conclusions hold: the bank must have better enforcement towards importers (
^
c c) and a more frequent
interaction to credibly oer guarantees.
18
Proposition 2 Consider the problem dened by equations (11) (18). The bank can provide
additional credibility through unconrmed letters of credit only if:
i) the bank has better enforcement towards importers,
ii) the bank interacts more frequently with exporters (to build higher reputation), and
iii) exporters can observe and punish deviations collectively.
When the importer IR constraint is binding and j = j
1
= o, (o 1) satises both equation 12
and 13, then rst best shipment is oered. If not, then the highest quantity that satises both
equations is oered.
A lolloi of ciooil inliooucos lwo IC consliainls in lho placo of lho singlo IC foi opon
accounl liansaclions. 1hoy Lolh musl suppoil
O
(as oolnoo Ly oqualion (0)) foi lho
Lank lo ciooiLly guaianloo highoi shipmonl lhan opon accounl. Whoioas oqualion (18) iolalos
lo lho quoslion of how Lanks can oloi moio ciooiLlo commilmonls lhan impoilois sopaialoly,
oqualion (12) iolalos lo lho quoslion of why Lanks as opposoo lo olhoi laigo onlilios piovioo
lhoso soivicos. 1his is oiscussoo in lho following soclion
4.2 The two agency problems of bank guarantees
Fiisl, lho Lank IC concoins lho oLligalions of lho Lank lowaios lho foioign oxpoilois, ano is
lho only inloinalional liaLilily of a lolloi of ciooil conliacl. Il oilois fiom lho opon accounl IC
consliainl of lho impoiloi lowaios lho oxpoiloi in lhioo ways: Fiisl, lho iopulalional concoin
is incioasoo Ly a highoi oiscounl facloi (c insloao of c
2
), socono, oocioasoo Ly lho facl lhal lho
Lank musl loavo somo of lho ionl wilh lho impoilois lo mool lhoii II consliainls, ano lhiio,
lho oulsioo valuo of lho gooo, ,, is iiiolovanl, as lho Lank nooo nol ongago in nogolialions
wilh lho oxpoiloi if il ionogos on paymonl (lho impoiloi is conliaclually oLligaloo lo pay
lho Lank iogaioloss). As only lho moio fioquonl inloiaclion loosons lho IC consliainl, il is
cloai why lho Lank nooos lo soquonlially guaianloo lho shipmonls; if only ono impoiloi woio
guaianlooo, lho iopulalional olocl woulo Lo insumcionl lo socuio paymonl. Il is impoilanl
lo nolo lhal il is nol lho sizo of lho Lank in ilsolf lhal guaianloos Lolloi ciooiLilily, Lul lho
moio fioquonl inloiaclion. If impoilois impoiloo ovoiy poiioo, lho Lank woulo soivo no iolo
regardless of wholhoi colloclivo punishmonl is possiLlo. Sizo, howovoi, plays an inoiiocl iolo
lhiough lho impoilanco of ionls. A monopolisl can oxliacl moio ionl fiom impoilois ano
can lhoiofoio ciooiLly guaianloo laigoi shipmonl. 1his is nol jusl a foaluio of lho assumplion
of full Laigaining powoi lo lho Lank. In soclion 6.1 il is oomonslialoo lhal lho inlioouclion
of an aooilional Lank ano compolilion Lolwoon lho lwo Lanks kooping lho assumplion ol
lako-il-oi-loavo-il olois iooucos ionls ano lhoioLy Lanks` aLilily lo guaianloo liaoo.
Whilo lho IC of lho Lank lowaios lho oxpoilois (oqualion (18)) piovioos a lhooiy foi how
Lanks can ciooiLly issuo guaianloos in inloinalional liaoo, lhoio is nolhing inhoionl in sizo lhal
ioquiios lnancial inslilulions. A possiLlo oxplanalion foi why Lanks piovioo lhoso soivicos is
10
pioviooo Ly lho IC of lho impoiloi lowaios lho Lank (oqualion (12)) Compaio lho impoiloi
IC lowaios lho Lank (oqualion ) wilh lhal of lho impoiloi IC fiom lho opon accounl pioLlom
lowaios lho oxpoiloi (oqualion (7)). Foi givon , oqualion (12) oilois fiom oqualion (7) of lho
opon accounl in lhioo ways: lho pioLaLilily lhal lho Lank can ioclaim lho monoy is

c ( c),
lho Lank cannol soizo lho gooos in caso of non-paymonl Ly lho impoiloi,
17
ano lnally lhoio
is a foo lo lho Lank foi lho soivico, making lho cosl highoi foi lho impoiloi ano lho inconlivo
lo ionogo highoi. Only lho lisl olocl suppoils a highoi shipmonl using lollois of ciooil, so

c c is a nocossaiy ioquiiomonl foi Lanks lo soivo a iolo. Il is impoilanl lo nolo lhal

c musl
Lo moio lhan maiginally highoi lhan c foi lho Lank lo ciooiLly guaianloo shipmonls. 1o soo
lhis, iowiilo oqualion (12) lo gol:
c
2
1 c
2
(j () c

) (1 c)
_

c c
_
c

_
_
c
2
1 c
2

_
1

c
_
_
1,
ano nolo lhal lho lwo lisl loims iopiosonl lho nol inconlivo lo oovialo hao Loon shippoo
using an opon accounl foi lho caso of , = 0. Using pioposilion 1,
O
implios lhal lho
sum of lhoso loims is nogalivo so

c maiginally highoi lhan c allows only foi a foo, 1, lhal
is maiginally highoi gioaloi lhan zoio. 1his is, howovoi, insumcionl lo guaianloo ciooiLlo
paymonl fiom lho Lank, as can Lo soon fiom lho IC consliainl c, (1 c) 1 _
_
1

c
_
c

.
1ho inconlivo lo honoi lho conliacl (lofl hano sioo) is piopoilional lo lho piolls oLlainoo
fiom lho liansaclion, 1, Lul lho inconlivo lo oovialo (iighl hano sioo) is piopoilional lo lho
entire liaLilily of lho Lank c

: lho Lank only collocls a small fiaclion of lho piolls Lul il can
ionogo on lho onliio amounl oulslanoing. Foi

c sumcionlly closo lo c, lho ionl collocloo is
insumcionl lo ciooiLly guaianloo paymonl. 1his piovioos a naluial oxplanalion foi why a local
Lank lypically lho iogulai Lank of lho impoiloi piovioos lho guaianloos. Il is familiai wilh
lho local logal fiamowoik ano has alioaoy sunk lho cosl of moniloiing lho impoiloi foi olhoi
puiposos, onaLling il lo oslaLlish signilcanlly highoi onfoicomonl wilh lho impoiloi lhan lho
oxpoiloi coulo.
18
Using pioposilion 2, il is sliaighlfoiwaio lo oomonslialo how liaoo vaiios wilh lho logal
17
Some letters of credit require for the importer to pay the bank before receiving the goods. In this case , = 0
reects the fact that the bank has no use of the goods. As argued in Petersen and Rajan (1997), the bank is
disadvantaged as a creditor compared with a supplier in that it has a lower resell value for claimed inventory.
18
Though the bank's better enforcement towards the importer is an exogenous assumption, expressions anal-
ogous to equation (12) could be derived endogenously in a setting like this in at least three ways. i) Let the
importer interact with two exporters sequentially every other period, and let neither observe behavior towards
the other. This yields the IC constraint of equation (7) when using open account. Using a letter of credit for both
with the same bank would yield an IC constraint of

1
(j (q) (c

+ 1)) q (1 c) (c

+ 1) q, which can im-

prove enforcement. ii) Alternatively, let the bank and importer interact every period in other respects, and let the
importer receive rents 1 over and above what could be achived with another bank, and let 1 be the corresponding
gain from deviation leading to an IC constraint of

2
1
2
(j (q) (c

+ 1)) q +

1
1 1

(1 c) (c

+ 1) q.
As long as

1
1 1, the bank obtains better enforcement. iii) Finally, increasing returns to scale in monitoring
would let the size of the bank matter along an additional dimension, as enforcing of multiple importers would
make enforcement towards each cheaper or more ecient.
20
fiamowoik c, ano lho oxpoilois` oulsioo valuo of lho gooo, ,. If (12) is Linoing lho analysis is
sliaighlfoiwaio: lho piolls lhal lho impoiloi collocls is incioasing in Lolh c ano , ano lhis
makos oovialion moio coslly so moio liaoo can Lo suppoiloo.
1ho moio inloiosling caso is whon lho shipmonl is consliainoo Ly lho Lank`s inconlivo lo
ionogo on paymonl; lhal is whon
G
is consliainoo Ly oqualion (18). Figuio illuslialos. 1ho
iighl hano sioo of lho oqualion is lho Lank`s inconlivo lo oovialo ano lho lofl hano sioo is lho
ionl il capluios. Wilh a Linoing impoiloi II, lho Lank musl guaianloo a quanlily sliiclly
highoi lhan opon accounl shipmonl lo capluio posilivo piolls, ano can only guaianloo lhoso
foi which lho cosl fiom oovialing is highoi lhan lho inconlivo lo oovialo, as shown in lho lguio.
Figuio . 1ho Lank IC consliainl
1ho quanlily
G
(c, ,) is lho highosl poinl (woakly lowoi lhan lisl Losl) foi which lhis is
liuo. Lolh , ano c incioaso H
O
ano ioouco lho piolls ano ciooiLilily of lho Lank. An incioaso
in c has lho aooilional olocl of making Lank oovialion moio coslly ano oocioasos lho inconlivo
lo oovialo. In gonoial lho ovoiall olocl is amLiguous.
4.3 Bank credibility and nancial crises
1ho quanlily guaianlooo,
G
(c, ,), is nol conlinuous in oilhoi c oi ,. 1his can Lo soon oiioclly
fiom lho lguio: if lho sol of quanlilios lhal can ciooiLly Lo guaianlooo (lho sol of poinls
aLovo cosl fiom oovialion" ano Lolow inconlivo lo oovialo") is small, minoi changos lo lho
paiamoloi spaco can loavo lho Lank unaLlo lo oloi any guaianloos. Il is oasily oomonslialoo
lhal lhis is lho caso foi c closo lo 1 oi , closo lo c

as lhis onsuios shipmonl of almosl pioll

maximizing quanlily loaving lilllo ionl foi lho Lank. Lanks lhoiofoio havo nolhing lo oloi
whon lho inilial holo-up pioLlom of lho opon accounl liansaclion is small, ano lho moool woulo
piooicl lilllo uso of lollois of ciooil whon lho conliacl onfoicomonl of lho ooslinalion counliy
is sumcionlly sliong oi oulsioo valuo is loo high.
A paiallol lo lho lalloi is sluoioo in a oomoslic conloxl Ly Ioloison ano Iajan (1007).
1hoy analyzo lho choico Lolwoon liaoo ciooil (oxlonooo Ly a supplioi) ano Lank lnanco ano
21
lno lhal lho oxlonl lo which a supplioi can iosoll lho gooos is posilivoly coiiolaloo wilh lho
oxlonsion of liaoo ciooil. 1his implios lhal sollois oxlonoing more liaoo ciooil woulo ioly less
on liaoo lnanco Ly Lanks, ano liaoo woulo Lo loss sonsilivo lo changos in lho Lank hoallh, in
lino wilh lho lnoings foi US oxpoils in Lovchonko et al. (2010). Inloioslingly, lhoy oo nol lno
lhis olocl foi US impoils, suggosling lhal guaianloos aio loss of a concoin wilh lho iolalivo
sliong conliacl onfoicomonl of lho US.
Lxlono lho moool slighlly such lhal lhoio is a pioLaLilily - lhal lho Lank will go Lankiupl.
As is slanoaio in moools of iopoaloo gamos, lhis oloclivoly changos lho oiscounl ialo of
lho Lank lo c (1 -). 1ho quanlily guaianlooo is naluially oocioasing in lho pioLaLilily of
Lankiuplcy, -, Lul as fiom lho analysis aLovo, lho chango can Lo oisconlinuous. AuLoin ano
Moioi-Lwoil (2008) ano AuLoin (2007) aiguo lhal lho conloonco in Asian Lanks consliainoo
lhoii aLilily lo ciooiLly issuo lollois of ciooil, which consliainoo Asian impoils ouiing lho
Asian ciisis. Loinaio et al. (2000) show lhal whoioas oxpoils lo lho US fiom counliios
suloiing fiom lho Asian ciisis showoo similai palloins foi iolaloo pailios ano aim`s longlh
liaoo, impoils fiom lho US lo lho samo counliios woio quilo oislincl: aim`s longlh liaoo
oioppoo Ly aiouno 20 poi conl, Lul impoils lhiough iolaloo pailios oioppoo only a fow poi
conl. Amili ano Woinsloin (2000) lno a similai oislinclion Lolwoon aim`s longlh ano iolaloo
pailios liaoo foi Japan in lho ninolios. As liaoo Lolwoon iolaloo pailios piosumaLly ioly loss
on Lank guaianloos lhis is consislonl wilho lhis lhooiy.
1ho moool suggosls lhal lho olocl of lnancial ciisos shoulo Lo viowoo lhiough Lanks` oual
iolo of piovioing liquioily ano guaianloos of paymonl. As aiguoo in Amili ano Woinsloin
(2000) Lolh channols aio likoly lo alocl inloinalional liaoo moio lhan oomoslic liaoo, as Lank
guaianloos aio moio commonly usoo in inloinalional liaoo ano lho lianspoilalion limo ano
lhoioLy liquioily nooo of inloinalional liaoo is lypically longoi.
19
ComLining Hummols`
(2001) woik on lianspoilalion limo ano lho sluoy Ly Djankov et al. (2010) on limo sponl in
cusloms, a shipmonl can oflon lako 6 wooks fiom oxpoiloi lo impoiloi, implying a suLslanlially
longoi liquioily nooo. Amili ano Woinsloin (2000) ano Lovchonko et al. (2000) lno lhal
lianspoilalion limo is an impoilanl piooicloi foi lho oiop in liaoo ouiing lho 2008-2000 ciisis
in Japan ano lho US, iospoclivoly, allhough inloioslingly only foi US impoils.
1ho signilcanl oiop in inloinalional liaoo ouiing lho 2008-2000 ciisis (Lalon et al., 2010
lno lhal gloLal liaoo lo GDI ooclinoo Ly noaily 80 poi conl ouiing iocossion) has inilialoo
a oiscussion aLoul lho impacl of liaoo lnanco. 1hough lho piosonl papoi ooos nol sook lo
answoi lhis quoslion, lho analysis piosonloo hoio suggosls lhal il is impoilanl lo consiooi
19
I examined an extension of the model with liquidity provision: If time between production and sales is T
periods, and per period gross interets rate is (1 + v), it is straightforward to demonstrate that for unconstrained
trade the sensititive to the interest rate is given by
Oq
O
Or
1+r
q
O
= To, and for constrained trade
Oq
O
Or
1+r
q
O
To,
such that longer transportation time increases the sensitivity to the cost of liquidity both for constrained and
unconstrained trade, but more so for constrained trade. The reason is that for constrained trade, the higher
liquidity cost reduces the rent to be obtained and the payment due, both of which increases incentive to renege.
22
how inloinalional liaoo oilois fiom oomoslic liaoo. If lho lwo channols piosonloo hoio aio
impoilanl wo shoulo soo liaoo oiopping oispiopoilionaloly foi impoiling counliios oi soclois
whoio conliacl onfoicomonl is moio of an issuo ano foi liaoo Lolwoon moio oislanl pailios.
Inloioslingly, whoioas lho analysis in Lalon et al. (2010) lnos lhal lho lion`s shaio of lho oiop
can Lo oxplainoo Ly changos in oomano ano loavo lilllo ioom foi liaoo fiiclions such as liaoo
lnanco, lhoii oala sol piooominanlly incluoos OLCD counliios. If lho lhooiy piosonloo hoio is
iighl, ano lianspoilalion limo ano onfoicomonl issuos aio impoilanl, lhon wo shoulo oxpocl lo
soo lilllo oispiopoilionalo olocl foi inloinalional liaoo in lhis samplo, which is oominaloo Ly
Luiopoan counliios of high pioximily lo oach olhoi ano wilh gooo inslilulions. Inloioslingly,
in lhoii analysis il is oxaclly foi China ano Japan lho counliios lho failhosl away fiom lho
coio of lho OLCD lhal liaoo fiiclions havo incioasoo lho mosl.
4.4 Reputation through size in international trade
1ho lwo IC consliainls of oqualions (12) ano (18) iopiosonl lho how ano why of Lank guaianloos
in inloinalional of lhis papoi: laigoi iopulalional capilal allows foi moio ciooiLlo piomisos of
paymonl ano lhoioLy a iolo foi laigo inslilulions, ano lho Lolloi onfoicomonl ano moniloiing
lhal comos wilh piovioing lnancial soivicos suggosl lhal lho iolo can naluially Lo poifoimoo
Ly lho iogulai Lank of lho impoiloi.
As lhoio is nolhing inhoionl in lho iopulalional aspocl of lho sloiy lhal ioquiios Lanks, lho
lhooiy can accommooalo olhoi laigo playois in inloinalional liaoo such as laigo inloimooiaiios
ano Lxpoil Ciooil Agoncios (LCA). Iossman (1084) shows lhal 800 (non-manufacluiing)
Japanoso lims accounloo foi 80 poi conl of Japanoso liaoo in lho 1080s, ano Ahn et al.
(2010) show lhal cuiionlly inloimooiaiios accounl foi 20 poi conl of Lolh Chinoso oxpoils ano
impoils. 1hoy aiguo lhal such inloimooiaiios allow a laigo sol of lims lo oxpoil inoiioclly
whon lhoy cannol aloio lo oo so oiioclly. 1hoy focus on oxogonous lxoo cosls of oxpoiling, Lul
lhis moool suggosls an alloinalivo oxplanalion: Many Chinoso lims aio loo small lo ciooiLly
ongago in inloinalional liaoo, so lhoso inloimooiaiios facililalo lho liaoo. Again lhis ioquiios
lwo lhings: lhoy havo lo Lo Lolloi aLlo lo onfoico qualily ano paymonl fiom Chinoso lims,
which suggosls lhoy shoulo Lo placoo in China, ano lhoii laigoi sizo allows lhom lo ciooiLly
ongago in inloinalional liaoo. 1his lls woll wilh lho ompiiical facl lhal lhoso inloimooiaiios
aio laigoi, focus moio naiiowly on pailiculai counliios lhan lims lhal oxpoil oiioclly such
lhal a iopulalion is moio oasily Luilo ano liaoo in a wiooi iango of piooucls. 1his is fuilhoi
oiscussoo in soclion 6.2, whoio il is fuilhoi aiguoo lhal inloimooiaiios aio a moio naluial
suLslilulos foi pio-paymonl conliacls lhan lollois of ciooil.
Aiouno 12 poi conl of woilo liaoo is mooialoo Ly LCAs (Gianluico, 2001). Allhough
pail of lho iolo of lhoso laigo inloimooiaiios is lo piovioo liquioily, lhoii aLilily lo onfoico
paymonl on Lohalf of foioign impoilois is an impoilanl aspocl. Whoioas a lolloi of ciooil is
28
usually issuoo Ly a Lank in lho impoiloi`s counliy, lho guaianlooing LCA is oflon localoo in
lho counliy of lho oxpoiloi. 1ho souico of lhoii highoi aLilily is lwo-folo: wilh LCA Loing
pailially govoinmonl-ownoo ano lho impoiloi oflon pailially oi fully ownoo Ly lho govoinmonl
of lho impoiling counliy, lho liaLilily lakos on a iolo similai lo sovoioign ooLl wilh suLslanlially
highoi polilical cosl of oofaull. Socono, lho Loino Union, an associalion of LCAs in Lonoon,
ioquiios all of ils momLois lo piovioo a lisl of Lao payois" (Lovil, 200), ano lho oiganizalion
lhoioLy incioasos lho cosl of oovialion foi lhoso impoilois. Lolh can Lo oiioclly inloipioloo
as a highoi

c.
4.5 The bank as a \long-run" player
1his papoi is closoly iolaloo lo lho liloialuio on lho inloiaclion Lolwoon long-iun" ano shoil-
iun" playois. FuoonLoig, Kiops ano Maskin (1000) ooiivo folk lhooioms" foi lhis lypo of
gamos, ano oomonslialo lhal long-iun playois can Lo oncouiagoo lo coopoialo if oovialions
againsl ono shoil-iun playoi is punishoo Ly suLsoquonl shoil-iun playois. Allhough lochnically,
lhoio aio no shoil iun playois in lho piosonl solling, lho infioquonl inloiaclion of impoiloi-
oxpoiloi paiis soivo a similai iolo, ano foi incioasingly infioquonl liansaclions (ioplaco 2 Ly
/ ano lol / ), lho lwo aio malhomalically ioonlical. Kiops (1006) ano Lull (1087) Lolh
analyzo lho inloiaclion Lolwoon a long-livoo lim ano shoil-livoo woikois, ano aiguo lhal lho
oxislonco of a iopulalion foi honosl Lohavioi onaLlos lho playois lo oscapo shoil-iun solf-
inloiosl. In Lull (1087), lho inlnilo lifo of a lim allows il lo oslaLlish a iopulalion foi paying
oul ono-of-caiiioi Lonusos foi high oloil, which again inoucos shoil-livoo omployoos lo piovioo
oloil. Kloin ano Lomoi (1081) analyzo lho inloiaclion Lolwoon a long-livoo lim ano a soiios of
shoil-livoo consumois, ano aiguo lhal concoin of iopulalion piovonls lho lim fiom oxploiling
shoil-iun gains fiom piooucing infoiioi qualily. An impoilanl aooilional foaluio of lho piosonl
papoi, is lho facl lhal whoioas ioal" shoil-iun playois aio complololy myopic, lho impoilois
hoio oo havo somo concoin foi lho fuluio lhal can suppoil liaoo, ano lho oxlonl lo which lhoy
can unooiminos lho aLilily of lho Lank lo ciooiLly guaianloo paymonls.
1hoso papois aio all caioful in slaling lhal a ioquiioo assumplion is lho aLilily of ono shoil-
iun playoi lo Lo infoimoo of ano punish lho long-iun playoi Lasoo on Lohavioi lowaios previous
shoil-iun playois. Foi lho maikol foi lollois of ciooil, lhis is nol an onliioly unioasonaLlo
oxplanalion. A numLoi of suivoys aio caiiioo oul oach yoai whoio issuois of liaoo lnanco
in a numLoi of counliios aio assossoo Ly oxpoilois Lasoo on ciiloiia such as sizo, piico, ano
cuslomoi soivico. 1hoso aio ioaoily availaLlo onlino (foi inslanco www.gfmag.com). Lolow, I
iolax lho assumplion of colloclivo punishmonl Ly inliooucing an aooilional Lank, on lho sioo
of lho oxpoilois, lo soivo lho iolo as an aooilional long-iun playoi.
24
5 Mutually conrmed letters of credit
A gioal ooal of lollois of ciooil aio conlimoo Ly an aooilional Lank, oflon localoo in lho counliy
of lho oxpoiloi. 1ho following soclion oxplicilly inliooucos an aooilional Lank, ono in foioign
ano ono in homo, lhal can oach mako lako-il-oi-loavo-il olois lo lhoii oomoslic impoilois as
oosciiLoo in soclion 4. As oomonslialoo Lolow lhis iomovos lho nooo foi colloclivo punishmonl,
as lho inloinalional liansaclion is only conoucloo Ly lwo pailios. 1o mako lho olocls of a
conliming Lank lho cloaiosl, I will mako lho following assumplion
Assumption 2 Collective punishment is not possible, that is the actions of the importer and
exporter in partial game i, cannot be made contingent on actions taken in partial game , ,= i.
Fiom pioposilion 2, unconlimoo Lank guaianloos aio nol possiLlo unooi assumplion 2.
1ho analysis so fai has focusoo on lho onfoicoaLilily issuos of impoils lo homo, Lul analogous
oxpiossions holo foi foioign impoils (oxpoils fiom homo). In pailiculai, a Lank in lho foioign
counliy will guaianloo lho paymonl lo homo oxpoilois on Lohalf of foioign impoilois. 1his Li-
laloial liaoo inliooucos an aooilional ioason foi mulually conlimoo Lank guaianloos: If Lanks
mulually conlim oach olhois` guaianloo, lho nol amounl nocossaiy lo liansfoi Lolwoon lho lwo
counliios ano lhoioLy lho amounl lo Lo oofaulloo on can Lo consiooiaLly smalloi.
20
In of-
focl, mulually conlimoo guaianloos pailially liansfoim inloinalional oLligalions inlo oomoslic
oLligalions, which aio moio oasily onfoicoo. 1his olocl is lho lopic of lhis soclion.
As can Lo soon fiom Figuio 1, lho conlimalion inliooucos lhioo agoncy pioLloms in lho
placo of lho lwo fiom lho unconlimoo lolloi of ciooil. 1ho onfoicomonl Lolwoon lho issuing
Lank ano lho impoilois is lho samo as Lofoio, ano lo avoio iopolilion I will assumo

c sumcionlly
high such lhal lho limiloo onfoicomonl pioLlom Lolwoon impoilois ano lho impoilois` Lank is
novoi a consliainl. 1ho only inloinalional oLligalions aio now Lolwoon lho lwo Lanks, Lul in
aooilion lho oxpoiloi musl onsuio lhal ho can collocl fiom lho conliming Lank. 1his coulo Lo
a soiious concoin in casos whoio conliacl onfoicomonl in lho oxpoiling counliy is woak. Sinco
lho main focus of lhis papoi is on lho onfoicomonl of inloinalional conliacls, I will sol asioo
lho onfoicomonl pioLlom Lolwoon lho oxpoiloi ano lho conliming Lank in lhis soclion Lul
aooioss il in .1 ano show lhal lhis naluially iolalos lo lho Lunoling of liquioily ano guaianloo
in lho lolloi of ciooil.
20
In the law literature, the concept is referred to as \set-o" or \netting" (McKnight, 2008 and Wood, 1980).
Although, the specic details vary across judicial systems, English law is clear on the matter: if a claim that
is due is not honored, the debtor has the right of set-o, and in the case of insolvency or bankruptcy, even
contract clauses specically specifying no set-o will typically be ignored (Wood, 1980, 7.4). Under French
law, matters seem to be somewhat less clear, but parties usually specify in letters of credit either international
arbitration or that a dispute is to be heard in London implying English law. This introduces an additional
point: as conicts are often heard in English courts, the expertise of these courts, as well as the relative strong
contract enforcement of English law, would give an additional argument in favor of letters of credit. Such is not
modeled explicitly here.
2
Iocall lhal ovoiy poiioo lhoio is a mass 1 of homo impoilois Luying oiloionlialoo gooos
fiom a mass 1 of foioign oxpoilois, ano a mass c of foioign impoilois Luying oiloionlialoo
gooos fiom lho homo counliy. 1ho paiamoloi capluios lho iolalivo iolianco of homo oxpoilois
on lollois of ciooil, ano will ooloimino lho oxlonl lo which nolling" is possiLlo. Foi low valuos
of c only fow homo oxpoilois ioly on lollois of ciooil whon oxpoiling lo lho foioign counliy.
21
1ho nolling is illuslialoo in lguio 6. 1ho solio linos iopiosonl shipmonls of gooos fiom a
homo oxpoiloi lo a foioign impoiloi, ano fiom a foioign oxpoiloi lo a homo impoiloi. 1ho
oolloo linos iopiosonl monoy liansfois coiiosponoing lo lhoso liansaclions. 1ho longlh of lho
linos coiiospono lo lho oollai valuo of lho shipmonl oi liansaclion. If lho lwo Lanks mulually
conlim oach olhois` guaianloos, lho nol amounl lo Lo liansfoiioo, ano lhoioLy lho possiLililios
of ionoging, aio suLslanlially iooucoo.
Figuio 6: Mulually conlimoo lollois of ciooil
1iaoo using lollois of ciooil is highoi fiom foioign lo homo.
Nolling" allows foi smalloi oulslanoing.
1o foimalizo lhis, I slighlly alloi lho gamo in soclion 4 such lhal lho lwo Lanks inilially
simullanoously oloi
_

A
, T
A
, 1
A
_
lo : _ 1 homo impoilois ano
_

A
, T
A
, 1
A
_
lo :

_ c
foioign impoilois ovoiy poiioo (Iocall lhal lhoio is a mass 2 of impoilois in lho homo counliy,
ano 2c in lho foioign counliy, half of which impoil ovoiy poiioo). 1hon lho homo Lank olois
lho foioign Lank lho oplion of mulually conliming lho lollois of ciooil wilh a nol liansfoi
fiom homo lo foioign Lank of A, ano lho foioign Lank oilhoi accopls oi iojocls. If il accopls
21
Alternative set-ups would lead to similar conclusions. I investigated a setup with heterogeneous rms where
a fraction endogenously chooses to rely on letters of credit depending on the institutional quality of the importing
country. This adds considerable complexity, but little insight on top of the ad hoc assumption presented here.
26
lho oloi lho slago piocooos as oosciiLoo in soclion 4. Again, I consiooi lho caso whoio lho
impoiloi II is Linoing
I will look foi a suLgamo poifocl oquiliLiium of lho samo lypo wilh lho aooilion lhal if
a Lank al any poinl oovialos fiom lho piosciiLoo slialogios, lho olhoi Lank will iofuso lo
ooal wilh il again. 1ho assumplion lhal colloclivo punishmonl is nol possiLlo lhon piovonls
fuluio liaoo Ly lollois of ciooil. Ly guaianlooing homo impoilois, lho homo Lank collocls
j
_

A
_

A
H
O
fiom oach of : homo impoilois, ano Ly conliming lho lollois of ciooil of
lho foioign Lank, il will lako upon ilsolf lho oLligalions of paying T

A
lo oach of :

homo
oxpoilois (lho oxpoiloi II is Linoing so T = c

ano T

= c). Analogous oxpiossions holo foi

lho foioign Lank, yioloing poi poiioo piolls of, iospoclivoly:
l = :
_
j
_

A
_

A
H
O

c
A
A, (14)
l

= :

_
j
_

A
_

A
H
O

:c

A
A. (1)
Ly lho assumplion of poifocl conliacl onfoicomonl oomoslically, lho Lanks cannol ionogo on
lho piomiso lo pay lhoii iospoclivo oxpoilois. In oquiliLiium c < 1 implios lhal al mosl lho
homo Lank IC will Lo Linoing. 1ho IC consliainl of lho homo Lank is lhoiofoio:
c
1 c
l _ (1 c) A. (16)
Lofoio oxplicilly solving foi a suLgamo poifocl oquiliLiium, consiooi lisl lho silualion in which
Lanks koop lhoii inloinalional oLligalions ano only conlim oach olhois` lollois of ciooil wilhoul
chaiging aooilional foos. In lhis caso lho liansfoi fiom homo lo foioign is lho oiloionco Lolwoon
whal is owoo foioign oxpoilois ano homo oxpoilois: A = :c

A
:

c
A
. Using (14) ano
(16) lhis givos:
c
1 c
_
j
_

A
_

A
c

A
H
O

_ (1 c) c

A
(1 c)
:

:
c
A
, (17)
which oilois fiom lho IC consliainl of lho unconlimoo lolloi of ciooil (conoilion (18)) only
in lho loim lo lho fai iighl: Ly mulually conliming lollois of ciooil, lho Lanks liansfoim
inloinalional oLligalions fiom Lanks lo ovoisoas oxpoilois inlo oomoslic oLligalions fiom Lanks
lo oomoslic oxpoilois, which aio lypically moio oasily onfoicoo (hoi poifoclly). 1ho loim is
naluially incioasing in :

,:, lho iolalivo impoilanco of foioign oLligalions, as lho nol amounl

lo Lo ionogoo on is smalloi.
In lho analysis of unconlimoo lolloi of ciooil wilh only ono Lank lho assumplion lhal
lho Lank hao all Laigaining powoi was naluial ano soivoo lo omphasizo lho iolo lhal posilivo
piolls play in onsuiing lho ciooiLilily of guaianloos (ano was nol ciucial foi lho analysis). Wilh
conlimoo guaianloos, lwo Lanks oxisl ano assigning full Laigaining powoi lo ono woulo Lo
aiLiliaiy. Insloao, I liaco oul lho suLgamo poifocl oquiliLiia lhal maximizo a Nash Laigaining
27
woighl of lhoii iospoclivo piolls:
max (l)

(l

)
1
, (18)
suLjocl lo conoilions (14) ano (1) wilh : _ 1 ano :

_ c. 1ho oulcomo is mosl oasily

analyzoo giaphically. Il is oomonslialoo in lho apponoix lhal :
A
= c ano j
_

A
_

A
= oH
O
is oplimal foi an inloiioi solulion. Wilh an aoooo iosliiclion lhal lho foioign Lank guaianloos
lisl Losl shipmonl foi foioign impoiloi (
A
=
1
), lho pioLlom is iooucoo lo choosing :

ano A lo maximizo (18) unooi lho conoilion of (16).

22
1his implios lhal lho iso-valuo cuivo of
(18) ano lho consliainl (16) can Lo liacoo oul in (A, :

) spaco as in lho lofl panol of lguio 7.

Iso-valuo cuivos lako incioasing valuo in lho soulh-oasl oiioclion. Only poinls lo lho noilhwosl
of lho homo Lank IC onsuio lhal lho homo Lank will koop lho oLligalion. A highoi valuo
of A incioasos lho inconlivo lo ionogo on paymonl foi lho homo Lank, which ioquiios highoi
poi-poiioo piolls of lho homo Lank, Ly incioasing :. 1ho iso-valuo cuivo is posilivoly slopoo
foi iolovanl paiamoloi valuos.
Figuio 7. 1ho IC consliainl of mulually conlimoo lollois of ciooil
Foi a givon valuo of lho suLgamo poifocl oquiliLiium is lhoioLy founo Ly lho poinl of
langoncy, as in lho lisl lguio, ano il can Lo oomonslialoo lhal highoi valuo of moio
woighl on homo Lanks` piolls will incioaso lho numLoi of impoilois lhal lho homo Lank
22
Imposing q
L
= q
T
is a restriction. Were q
L
allowed to vary freely q
L
q
T
would be optimal; that
is the foreign bank would guarantee a shipment higher than rst best, as this would increase the obligations
of the foreign on towards the home bank, which reduces the home bank's incentive to renege. Allowing this
would complicate the graphical analysis but would quilitatively yield the same results. The question of whether
banks depending on mutual business make otherwise inecient decisions to reduce the incentive constraint is
interesting but will not be addressed here.
28
can suppoil. 1his miiiois lho iosull lhal lho moio pioll lho homo Lank can oxliacl fiom lho
impoilois, lho moio ciooiLlo is ils commilmonl lo honoi ils oLligalions.
Losioos lho facl lhal lho assumplion of colloclivo punishmonl is no longoi nooooo, conlimoo
lollois of ciooil ioly ciucially on Lilaloial liaoo in guaianlooo shipmonls lo facililalo highoi
liaoo lhan whal is possiLlo unooi unconlimoo lollois of ciooil. 1his is summaiizoo in lho
following pioposilion.
Proposition 3 Without collective punishment (assumption 2), conrmed letters of credit can
increase trade. With mutually conrmed letters of credit
a) Ecient trade can be supported for foreign importers: :
A
= c and
A
=
1
.
b) The amount of trade that can be guaranteed by home banks, :
A

A
, is increasing in c, the
number of foreign importers using letters of credit.
c) The amount guaranteed is increasing in , the weight on the home banks utility function.
Proof. In apponoix
1ho pioposilion makos lho lwo aovanlagos of mulually conlimoo lollois of ciooil cloai.
Fiisl, lho assumplion of colloclivo punishmonl is no longoi nocossaiy, ano socono, nolling
iooucos lho amounl oulslanoing lo Lo oofaulloo on, ano incioasos ciooiLilily. In olocl, lho
mulual conlimalion liansfois inloinalional oLligalions Lolwoon Lanks ano oxpoilois aLioao
inlo oomoslic oLligalions Lolwoon Lanks ano oxpoilois in lho samo counliy. As conliacl
onfoicomonl is Lolloi oomoslically (hoio poifocl) lhis iooucos lho iisk of ionoging.
Iail L) of lho pioposilion is illuslialoo in lho iighl panol of Figuio 7. A lowoi numLoi of
foioign impoilois ioquiiing guaianloos lowois lho IC consliainl of lho impoiloi ano iooucos
lho numLoi of impoilois lhal lho homo Lank can guaianloo fiom :
A
lo :
A0
. 1ho inluilion
follows oiioclly fiom (17): if lho foioign Lank guaianloos fowoi foioign impoilois impoiling
fiom homo, lho nolling olocl is smalloi, ano lho oulslanoing amounl foi lho homo Lank is
laigoi. 1his oulslanoing amounl musl Lo lowoioo Ly iooucing lho numLoi of impoilois lhal
aio oloioo a guaianloo.
Iail c of lho pioposilion omphasizos an aooilional olocl of lho conliming lolloi of ciooil:
lho moio Laigaining powoi lho foioign Lank holos (lowoi ), lho loss ionl lho homo Lank can
oLlain, ano lho inconlivo lo ionogo incioasos.
In lho lhooiy piosonloo in lhis soclion Lanks` only iolo is lho piovision of lollois of ciooil.
In ioalily Lanks ongago wilh oach olhoi in a numLoi of ways Losioos lhoso lolloi of ciooil,
oflon wilh amounls oulslanoing Lolwoon lhom lhal aio oiooi of magniluoo highoi lhan lhoso
of lollois of ciooil (ooiivalivos, cuiioncy liaoing olc.), 1his makos lho amounl oulslanoing
on lollois of ciooil a small fiaclion of a Lank`s lolal gioss oulslanoings. 1his suggosls an
aooilional ioason foi why Lanks ano nol spocializoo inslilulions hanolo lho majoiily of lollois
of ciooil: lho cosl of ionoging on a lolloi of ciooil is nol jusl Loing cul ol fiom lho lolloi of
20
ciooil maikol, Lul also lho cosl of Loing cul ol fiom olhoi inloinalional aclivilios ciucial foi
lho woll-funclioning of mosl moooin Lanks.
5.1 Bundling of liquidity and guarantee in the letter of credit
Mulually conlimoo guaianloos pailially liansfoim lho inloinalional oLligalions of Lanks lo-
waios ovoisoas oxpoilois inlo oomoslic oLligalions lowaios oomoslic oxpoilois. Naluially,
lhis woiks only if lhoso oomoslic conliacls can Lo Lolloi onfoicoo. 1his is lho unooilying
assumplion of lho papoi Lul naluially lhoio mighl Lo silualions in which lhis is nol liuo. 1his
iolalos naluially lo lho Lunoling of liquioily ano guaianloo in lho lolloi of ciooil: Consiooi
an oxpoiloi ongagoo in inloinalional liaoo. Ho sooks lho assislanco of Lanks Lolh lo oLlain
liquioily ano lo oLlain guaianloos lhiough a conlimoo lolloi of ciooil. If ho sooks lho soivicos
fiom lwo sopaialo Lanks, lhoio oxisls lwo agoncy pioLloms: lho Lank piovioing liquioily nooos
lo onsuio iopaymonl fiom lho oxpoiloi, ano lho oxpoiloi nooos lo onsuio lhal ho is paio Ly lho
conliming Lank. If, howovoi, lho samo Lank piovioos Lolh iolos, lhoso lwo agoncy pioLloms
cancol oul: lho Lank will inilially pay lho oxpoiloi in full ano only has lo collocl fiom lho
issuing Lank. 1ho oxpoiloi, having alioaoy socuioo his paymonl, facos no iisk.
23
6 Extensions
In lho main moool lho focus is on Lanks` iolo in guaianlooing lhal lho oxpoiloi iocoivos pay-
monl. 1ho iolo of iopulalion ano Lanks` aLilily lo oxliacl piolls in oslaLlishing ciooiLilily of
Lank guaianloos aio omphasizoo Ly assuming lho oxislonco of a monopolisl Lank. In lho fol-
lowing, I oxplicilly analyzo local compolilion Lolwoon Lanks ano oomonslialo lhal compolilion
iooucos ionl ano lhoioLy liaoo. II lhon consiooi lho choico Lolwoon pio-paymonl ano opon ac-
counl ano aiguo lhal whoioas Lank guaianloos aio a naluial alloinalivo lo opon accounl whoio
lho concoin is non-paymonl, inloimooiaiios aiiso as a naluial alloinalivo lo pio-paymonl whoio
lho concoin is pooi poifoimanco on qualily.
6.1 Competition of banks
1ho lhooiy piosonloo hoio naluially iolios on posilivo piolls lo suslain an inconlivo foi honosl
Lohavioi.
24
1his, along wilh lho facl lhal lho inousliy is usually ialhoi conconlialoo, Logs
lho quoslion: how woulo incioasoo compolilion alocl lho maikol oulcomos 1ho quoslion is
analyzoo in a solling of ouopoly in lho maikol foi issuanco of guaianloos.
23
More specically, the foreign exporter takes on debt of 1 = c

q
C
from the bank providing the liquidity
(ignore interest rates), and the bank guarantees the payment of T
C
q
C
= c

q
C
, such that the net outstanding
from exporter to bank is 1 T
C
q
C
= c

q
C
c

q
C
= 0.
24
Klein and Leer (1981) show a similar result in the context of a \brand" producer where rents are necessary
for the producer not to shirk on quality.
80
1hoio aio lwo Lanks, Lank ano ano Lank 1, Lolh oloiing lollois of ciooil lo homo
impoilois. Foi simplicily I consiooi only unconlimoo lollois of ciooil (so assumplion 2 no
longoi holos). Allhough Lanks oloi a homogonous piooucl (a conliacl oloiing lo guaianloo
as shipmonl al a foo 1), lhoy oiloi in lhoii aLilily lo moniloi impoilois. In a slighl oovialion
fiom lho solup aLovo, Lank , , 1 can moniloi impoiloi i al cosl :
)
(i). Impoilois aio
localoo along a lino sogmonl of longlh 1 (wilh oonsily 2), ano lho lwo Lanks aio localoo al 0
ano 1, iospoclivoly, as oiiginally analyzoo in Hololling (1020). Again, half of lhoso impoilois
will Lo aclivo ovoiy poiioo. Lul whoioas lho oiiginal moool was aLoul lianspoilalion cosls
oi moio gonoially hoiizonlal oiloionlialion, lho oislanco lo lho Lank of a givon impoiloi i is
piopoilional lo lho moniloiing cosls of lhal Lank. 1his is moanl lo capluio lho nolion lhal
Lanks havo vaiying familiaiily wilh impoilois. 1ho moniloiing cosls aio:
:

(i) = :i,
:
1
(i) = :(1 i) ,
whoio lho paiamoloi : is an invoiso moasuio of lho lovol of compolilion: wilh high :, lhoio aio
laigo cosl oiloioncos in moniloiing, ano Lanks can havo laigoi maikol powoi wilh impoilois.
1ho Lanks aio ongagoo in Loiliano compolilion. 1ho only oiloionco fiom lho gamo in soc-
lion 4 is lhal Lanks now simullanoously oloi a lolloi of ciooil conliacl
_

(i) , T

(i) , 1

(i)
_
ano
_

1
(i) , T
1
(i) , 1
1
(i)
_
, i [0, 1[, iospoclivoly lo all impoilois, ano impoilois chooso Lo-
lwoon lhoso lwo ano opon accounl. 1ho gamo lhon piocooos as oosciiLoo foi unconlimoo
lollois of ciooil aLovo.
I consiooi slialogios of lho following foim: All Lanks oloi conliacls lo all impoilois. If a
Lank has nol pioviously oovialoo, lho conliacl is lakon lo Lo ciooiLlo. If il has, no conliacl
is accoploo. 1ho impoiloi choosos lho ciooiLlo conliacl lhal maximizos piolls fiom opon
accounl ano lho lwo Lanks` oloioo lollois of ciooil conliacls. 1ho IC consliainl aio:
c
1 c
_
a
/
0
_
1

(i) :
i
_

(i) di = (1 c) c

_
a
/
0

(i) di, (10)

c
1 c
_
1
a
T
_
1
1
(i) (1 :
i
)
_

1
(i) di = (1 c) c

_
1
a
T

1
(i) di, (20)
whoio Lank guaianloos [0, r

[ ano Lank 1 guaianloos [r

1
, 1[, ano r

_ r
1
. A canoioalo
foi a suLgamo poifocl oquiliLiium of lhis lypo musl havo conliacls
_

(i) , T

(i) , 1

(i)
_
ano
_

1
(i) , T
1
(i) , 1
1
(i)
_
lhal aio immuno lo lho following unooiculling in piico (a full foimal
oosciiplion of lho gamo is availaLlo on lho aulhoi`s woLsilo):
Consiooi Lank . Foi a Linoing IC consliainl (10), Lank can sloal" a clionl i
0
[r
1
, 1[
fiom Lank 1 (lochnically, il will sloal lwo, ono fiom oach alloinaling poiioo) if il olois a Lolloi
conliacl lhal ooos nol lighlon lho IC consliainl, which ioquiios
c
1c
_
1

(i
0
) :(i
0
)

(i
0
) _
81
(1 c) c

(i
0
). As impoiloi piolls aio H
_

(i
0
) , 1

(i
0
)
_
=
_
j
_

(i
0
)
_

_
c

(i
0
)
_

(i
0
),
lho highosl piolls lhal Lank can oloi impoiloi i
0
wilhoul lighloning ils own IC is:

H
_
:

_
i
0
__
= j ( ) c

j :

_
i
0
_
,
wilh j ( ) = o, (o 1) j ano j = (1 c) (1 c) ,c 1. Lank can piollaLly oo lhis foi
any oquiliLiium whoio Lank 1 olois impoiloi i
0
loss lhan

H(:

(i
0
)). Foi simplicily consiooi
lho caso whoio min
_

H(:

(i)) ,

H(:
1
(i))
_
_ H
O
such lhal Lolh Lanks can oloi a conliacl
supoiioi lo opon accounl, ano an Impoiloi II consliainl liko (12) is non-Linoing. Symmoliy
lhon loaos lo an IC consliainl of Lank 1 of:
25
c
1 c
_
1
12
_
j
_

1
(i)
_

1
(i)

H(:

(i)) :
1
(i)
_
di _ (1 c)
_
1
12

1
(i) di,
which is a oiiocl paiallol lo oqualion 18 in soclion 4.1, Lul wilh lho oulsioo oplion foi lho im-
poiloi Loing lho olhoi Lank, ano nol opon accounl shipmonl. Consiooi a Linoing IC consliainl,
ano oiloionlialo lho lofl hano sioo wil : :

c
1 c
_
1
12
_
0

H(:

(i))
0 :

0:
1
(i)
0 :
_
di. (21)
Wilh 0

H(:

(i)) ,0 : = i ano 0:
1
(i) ,0 : = (1 i) ano lho inlogial iunning fiom 1,2 lo
1, lho ooiivalivo is posilivo: an incioaso in : loosons lho IC consliainl ano allows foi highoi
shipmonl. Consoquonlly, moio compolilion a oiop in : lighlons lho IC consliainl ano
iooucos lho aLilily of Lanks lo guaianloo shipmonls. 1hoio aio lwo opposilo olocls: on lho ono
hano, a oocioaso in : iooucos lho moniloiing cosl ano incioasos ionl ano lhoioLy ciooiLilily.
On lho olhoi hano, a oocioaso in : impiovos lho aLilily of Lank lo poach lho clionls of
Lank 1, which iooucos piollaLilily ano lhoioLy ciooiLilily. 1hal lho socono olocl oominalos
is pailiculai lo lho piosonl solling, Lul lho oxislonco of lwo opposilo olocls is moio gonoial.
1ho quoslion of wholhoi compolilion Lolwoon Lanks is wolfaio impioving is wiooly oiscussoo
in lho liloialuio (Allon ano Galo, 2001, chaploi 8 piovioo a ioviow). Allhough lho piimaiy
focus of lho aulhois is on how loo much compolilion mighl loao lo oxcossivo iisk laking, lhoy
aiguo lhal Lianch Lanking (fow laigo playois wilh many Lianchos) can Lo Iaiolo supoiioi
Locauso il allows Lanks lo Luilo iopulalions foi honosl Lohavioi. Allhough similai lo lho
aigumonl piosonloo hoio, whal is ciucial foi oqualion (21) is lhal lho lowoi piolls lhal follow
fiom lighloi compolilion unooimino lho ciooiLilily of lho Lanks ano allow lhom lo piovioo
fowoi guaianloos.
25
One can show that the quantity q
T
(i) will be the same for all importers guaranteed, though this is not
relevant for the argument that follows.
82
6.2 Open account versus pre-payment
1ho main loxl focusoo on lho choico Lolwoon opon accounl ano Lank guaianloos. 1his soclion
analyzos lho caso of pio-paymonl ano aiguos lhal inloimooiaiios can soivo a iolo analogous
lo lho Lanks aLovo in guaianlooing high qualily shipmonl. Chango lho gamo such lhal lho
paymonl T
1
(1 foi pio-paymonl) is ouo Lofoio lho shipmonl is maoo. 1his has lo implicalions:
Fiisl, as il is now lho impoiloi who Loais lho liquioily cosl, il is nocossaiy lo Lo oxplicil
aLoul lho oiloionl liquioily cosl in lho lwo counliios. Lol lho inloiosl ialo in homo Lo r
ano lho foioign inloiosl ialo Lo r

such lhal lho cosl of pioouclion using opon accounl is

c

= (1 r

) c

, whoioas if lho impoiloi Loais lho liquioily cosl sho will pay an inloiosl ialo
of r. Socono, as lho oxpoiloi iocoivos lho monoy up-fionl, lho holo-up pioLlom changos fiom
lho shoil iun inconlivo of lho impoiloi claiming low qualily gooos lo lho oxpoiloi making low
qualily gooos. If lho impoiloi iocoivos low qualily gooos afloi having paio, sho can suo in lho
foioign couils ano wilh a pioLaLilily j

0 lho couils will iulo in hoi favoi, in which caso

sho is ioluinoo lho paymonl T
1
.
26
If lhoy oo nol, lho oxpoiloi can koop lho paymonl. Again,
ono can oomonslialo lhal no slialogios can suppoil a conliacl Lolloi lhan lho simplo liiggoi
slialogios of iovoiling lo no liaoo foiovoi.
1o simplify lho analysis, assumo lhal a foioign couil can poifoclly voiify if lho oxpoiloi sonl
a high qualily shipmonl, so lhoio is no IC consliainl lo piovonl lho impoiloi fiom oishonoslly
claiming low qualily. 1ho conliacl
_
T
1
,
1
_
lhal maximizos piolls unooi lho conoilion of
Loing suppoilaLlo Ly a suLgamo poifocl oquiliLiium is givon Ly:

\
1
= max
q,T
j () (1 r) T c
2

\
1
, (22)
suLjocl lo:
Iiooucoi IC:

\
A
=
1
1 c
2
[T c

[ _ (1 j

) T, (28)
whoio

\
1
ano

\
A
aio lho valuo funclions using pio-paymonl ano now lho impoiloi Loais lho
liquioily cosl. 1ho lofl hano sioo of lho oxpoiloi IC is lho lolal oiscounloo valuo of fuluio
liaoo, whoioas lho iighl hano sioo is lho oxpocloo gain fiom oovialing. 1hoio is no cosl of
piooucing low qualily gooos, Lul lhoio is a pioLaLilily j

lhal lho impoiloi wins lho caso ano

26
This assumption is not inconsistent with the home court's ability to perfectly verify a good to be of low
quality. Once the payment has been made, the importer must seek repayment from the producer in a foreign
court for goods that have already arrived in the home country, which increases the burden of proof (since the
goods are in a dierent country) and exposes the importer to the complexities and possible biases of a foreign
court system. Only the assumption that the importer stands a better chance in the legal system of the importing
country than in the exporting country is necessary.
88
T is losl.
27
A Linoing IC consliainl givos a iosull analogous lo pioposilion 1:
28
j
_

1
_
=
o
o 1
(1 r) c

1
_
1 c
2
_
(1 j

)
. (24)
Naluially, lho oplimal shipmonl is incioasing in, j

, lho impoiloi`s aLilily lo win in couil

shoulo lho oxpoiloi ship low qualily. Lol piolls fiom using pio-paymonl Lo H
1
= j
_

1
_

T
1

1
, whoio T
1
is givon Ly a Linoing (28). Conlinuing lo focus on lho SIL lhal maximizos
impoiloi piolls, lho quoslion of foim of shipmonl is maoo Ly compaiing H
O
ano H
1
. 1his
loaos lo lho following pioposilion:
Proposition 4 Comparing the SPEs that maximize importer prots under open account and
pre-payment, there is a cut-o value

, for which the importer is indierent between open
account and pre-payment. It is dened by
H
1
(r, c, j

) = H
O
_
r

, c, c,

,
_
(2)
All importers with , _

, (r, j

, c, r

, c) will choose open account, and all , <

, will choose
pre-payment.

, is decreasing in importer legal quality c, and the importer's interest rate, r

.
It is increasing in the quality of the foreign legal environment j

, and the interest rate of the

importer.
Proof. Follows oiioclly fiom implicil oiloionlialion of oqualion (2).
1ho lisl pails of lho pioposilion follow naluially fiom lho oiscussion aLovo: lho Lolloi is
lho iolalivo conliacl onfoicomonl in lho juiisoiclion of lho polonlial ionoging paily impoiloi
foi opon accounl ano oxpoiloi foi pio-paymonl lho moio likoly a conliacl lhal loavos lho
inconlivo lo choal on lhis paily. Similaily, lho liquioily cosl shoulo Lo shifloo lo lho paily wilh
lho lowosl cosl. 1ho oulsioo valuo of lho gooo, ,, only alocls lho opon accounl liansaclion, so
highoi oulsioo oplion, which incioasos lho iolalivo Laigaining silualion of lho oxpoiloi in caso
of oispulo, will incioaso piolls fiom opon accounl. 1his suggosls lhal gooos lhal aio oasily
iosolo oi salos lo maikols lhal aio closoi shoulo moio oflon Lo soivoo Ly opon accounl. 1ho
lasl lnoing is in lino wilh Anli`as ano Foloy (2010).
1ho ciucial oiloionco Lolwoon lho agoncy pioLloms of opon accounl ano pio-paymonl
mako il cloai why lollois of ciooil aio Lolloi suLslilulos foi opon accounl: Lanks havo lilllo
oxpoiliso in onfoicing qualily fiom lho oxpoiloi. A lhooiy of inloimooiaiios, howovoi, coulo Lo
27
One could introduce additional costs for breach of contract (expectation damages in fact would allow the
importer to claim j (q) from the producer). Yet, with a wealth constraint, no more than T can be recouped
from the producer.
28
Again, the choice of a particular Pareto-optimal subgame perfect equilibrium is not essential. Letting
2 [0, 1] be the weight on the importer's utility function, the quantities shipped for the full set of equilibria of
the trigger type is described by: j (q) =

T
2
1(1p

)(1
2
)
. A higher weight on the importer's utility (higher
) implies a higher incentive for cheating on quality for the exporter and a lower shipment can be supported.
84
consliucloo along lho linos hoio lo soivo lhal iolo. Inloimooiaiios, woulo Lo laigo consislonl
wilh lho lnoings in Ahn et al. (2010) so as lo Lo aLlo lo ciooiLly guaianloo lho shipmonl of
high qualily gooos, ano lhoy woulo spocializoo in a fow maikols (ano localoo in lho counliy
of lho oxpoilois) so as lo Lo Lolloi aLlo lo onfoico pioLoi qualily fiom lho oxpoilois. 1hoso
facls aio consislonl wilh lho iolo of many inloimooiaiios facililaling oxpoils fiom oovoloping
counliios.
7 Conclusion
Woak conliacl onfoicomonl is an impoilanl aspocl of inloinalional liaoo. I aiguo lhal guai-
anlooing Lanks, laigo inloimooiaiios, ano LCAs can Lo soon as mochanisms foi oslaLlishing
iopulalion foi lims unaLlo lo oo so lhomsolvos. 1ho spocilc focus of lho papoi is on Lanks`
iolo in guaianlooing paymonl Ly impoilois. 1ho papoi piocooos in lhioo slops: Fiisl, il is
oomonslialoo lhal lims lhomsolvos can ovoicomo limiloo onfoicomonl issuos if lhoy aio a
pail of nolwoiks oi inloiacl sumcionlly oflon. Socono, foi lims whoio lhis is nol possiLlo
a Lank moio fioquonlly inloiacling can impiovo mallois if il can oxliacl sumcionl piolls
ano oxpoilois can colloclivo punish il Ly wilhoiawing Lusinoss if il ionogos on ono of lhom.
1hiio, a conliming Lank of lho oxpoilois is shown lo ovoicomo lho assumplion of colloclivo
punishmonl ano fuilhoi mulually conlimoo guaianloos fuilhoi inliooucos nolling": whon
Lanks havo mulual oulslanoings. on oach olhoi lhoy can only ionogo on lho nol amounl ano
suslaining honosl Lohavioi is oasioi. 1ho analysis suggosls a conconlialoo inousliy in which
Lanks inloiacl iopoalooly wilh lho samo pailios inloinalionally in lino wilh oLsoivoo palloins.
1ho papoi olois aooilional ompiiical piooiclions ano policy implicalions. Il piooicls lhal
nolwoiks ano lollois of ciooil aio mosl impoilanl foi counliios wilh woak conliacls ano foi
spocializoo gooos which iocoivos suppoil fiom lho limiloo ompiiical sluoios availaLlo. Fuluio
sluoios using micio oala of lho choico of conliacls will shoo fuilhoi lighl on lho impoilanls of
woak conliacl onfoicomonl ano iopulalions foi inloinalional liaoo. 1ho lhooiy fuilhoi piooicls
lhal conliacls in inloinalional liaoo shoulo in gonoial Lo oosignoo such lhal lho laigoi playoi
has lho Liggosl inconlivo lo oovialo; ils laigoi sizo will mako oovialion moio coslly if olhois
can oLsoivo ils Lohavioi.
1ho lhooiy sopaialos lho iolos of Lanks as piovioois of liquioily ano guaianloos ano aiguos
lhal lho hoallh of lho lnancial syslom can alocl liaoo lhiough Lolh channols. 1ho liquioily
channol ooponos ciilically on lho longlh of lho liansaclion, whoioas lho guaianlooing aspocl
ooponos ciucially on lho lypo of gooo ano lho conliacl onfoicomonl of lho impoiling counliy.
In piinciplo il shoulo Lo possiLlo lo oislinguish Lolwoon lho lwo ompiiically. Naluially, a moio
oiiocl ompiiical analysis wilh Lank-lim oala woulo Lo valuaLlo.
1ho iosull lhal small changos lo paiamolois can havo oisconlinuous olocls on Lanks` aLilily
lo guaianloo has lwo implicalions: Fiisl, in limos of ciisis oloiing govoinmonl guaianloos can
8
holp suslain ciooiLilily ano suppoil liaoo. Socono, changos in lho compolilivo sliucluio oi lho
iogulaloiy onviionmonl such as a possiLlo incioaso in capilal ioquiiomonl on liaoo lnanco
in lho Lasol III accoio can oocioaso piolls ano havo aovoiso olocls on Lanks` aLilily ano
willingnoss lo oloi guaianloos.
Finally, lo focus on Lanks` iolo in facililaling iopulalions lho analysis hoio is limiloo lo
lims oxogonously lockoo inlo iolalionships ano Lanks aio lho only inloimooiaiios consiooioo.
Lxamining lho choico of liaoo pailnois ano lho iolo of laigo inloimooiaiios in lho lighl of
iopulalions is an inloiosling lopic foi fuluio iosoaich.
86
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40
8 Appendix
8.1 The letter of credit contract
1his apponoix givos a moio oolailoo oosciiplion of lho logal oolails of a lolloi of ciooil ano how
lho oxoculion is oflon oono. Soo McCullough (1087) foi a compiohonsivo oosciiplion of lollois
of ciooil oi ool Luslo (1004) foi a piaclical usoi`s guioo. Figuio 8 Lolow illuslialos a lypical
voision of lho liansaclions in an unconlimoo lolloi of ciooil. 1ho impoiloi oiiginally nogolialo
a salos conliacl ano agioo upon lho uso of a lolloi of ciooil. 1ho lolloi of ciooil is a logal
oocumonl sopaialoo fiom lho unooilying salos conliacl in lhal il ooals sololy in oocumonls ano
nol lho unooilying liansfoi of gooos. Onco lho lolloi of ciooil ano lho salos conliacl havo Loon
agiooo upon Ly all pailios lho aclual shipmonl of gooos can lako placo. Whon lho oxpoiloi
ships lho gooos fiom his poil ho oLlains oocumonls fiom lho shipping company nocossaiy
lo claim lho gooos fiom lho poil of lho impoiloi. 1ho oxpoiloi sonos lhoso oocumonls lo
lho issuing Lank ano lho lolloi of ciooil ioquiios paymonl, lypically al lho limo of iocoipl (on
sighl), Lul occasionally laloi. 1ho issuing Lank lhon foiwaios lhoso oocumonls lo lho impoiloi
who nooos lhom lo claim lho gooos whon lhoy aiiivo. Wholhoi lho Lank ioquiios immooialo
paymonl fiom lho impoiloi ooponos on lho spocilc oolails of lho lolloi of ciooil. Onco lho
impoiloi has iocoivoo lho oocumonls sho can claim lho gooos fiom lho shipping company.
Figuio 8. 1ho oocumonls of a lolloi of ciooil
8.2 Open account. Denition and subgame perfection
1his apponoix foimally slalos lho opon accounl gamo Lolwoon lho oxpoiloi ano lho impoiloi,
oomonslialo lhal lho pioposoo slialogios in lho main loxl aio suLgamo poifocl. 1ho full gamo
is lho following slago gamo iopoaloo ovoiy olhoi poiioo, t = 0, 2, 4, ..
1. Dolnilion of slago gamo. 1ho slago gamo al t has lwo playois: oxpoiloi ano impoiloi.
I splil lho slago gamo inlo 4 suLslagos, whoio oach coiiospono lo a oocision nolo. suLslago
41
t
0
: Lolh impoiloi ano oxpoiloi oocioo wholhoi lo ongago in liaoo (:
c
t
= 1, : = 1, A) oi nol
(:
c
t
= 0, : = 1, A). 1ho slago gamo conlinuos only if :
1
t
:
A
t
= 1. SuLslago t
1
: impoiloi
olois a conliacl C
O
t
= (
t
, T
t
) R
+
[0, j (
t
)[, whoio T
t
is paymonl poi unil ano impoiloi
is woallh-consliainoo, T
t
_ j (
t
). SuLslago t
2
: Iiooucoi ships
A
t
0,
t
(whoio
A
t
= 0 is
nol accopling). If lho oxpoiloi ships
A
t
=
t
lho gamo piocooos lo suLslago t
3
. SuLslago t
3
:
impoiloi oilhoi pays (T
1
t
= T
t
poi unil) oi nol (T
1
t
= 0). (
t
, T
t
) is lhoioLy lho conliacl, ano

A
t
ano T
1
t
lho coiiosponoing oocision Ly lho oxpoiloi ano impoiloi, iospoclivoly, lo aohoio lo
il.
2. Iayols
If no shipmonl has Loon maoo, pay-ol is zoio foi Lolh pailios. If shipmonl has Loon
maoo, ano lho impoiloi pays lho pay-ols foi lhis poiioo aio (j (
t
) T
t
)
t
ano (T
t
c

)
t
foi impoiloi ano oxpoiloi, iospoclivoly. If impoiloi ooos nol pay, lho caso goos lo couil, ano
oxpocloo paymonl fiom impoiloi lo oxpoiloi is cT
t
(1 c) , poi unil, ano oxpocloo piolls
aio j (
t
)
t
[cT
t
(1 c) ,[
t
ano [cT
t
(1 c) ,[
t
, iospoclivoly. Ilayois oiscounl lho
pay-ols Lolwoon gamos wilh c
2
.
8. Oulcomos
Lol an oulcomo of suLgamo t Lo a
t
=
__
:
1
t
, :
A
t
_
, (
t
, T
t
) ,
A
t
, T
1
t
_
foi t = 0, 2, 4, .... Using
lhis, I oolno a lypo of hisloiy foi oach lypo of suLslago, iospoclivoly:
/
_
t
0
_
= (..., a
t4
, a
t2
)
/
_
t
1
_
= /
_
t
0
_
'
__
:
1
t
, :
A
t
__
/
_
t
2
_
= /
_
t
1
_
' (
t
, T
t
)
/
_
t
3
_
= /
_
t
2
_
'
_

A
t
_
,
wilh lho sol of possiLlo hisloiios coiiosponoingly oolnoo as H
_
t
i
_
foi i = 0, 1, 2, 8. Consiooi
a givon conliacl
_

O
, T
O
_
ano oolno lho coiiosponoing oulcomo in slago gamo t a

t
_

O
, T
O
_
=
_
(1, 1) ,
_

O
, T
O
_
,
O
, T
O
_
as lho oulcomo of a gamo foi which lho conliacl
_

O
, T
O
_
is pio-
posoo ano aohoioo lo Ly Lolh pailios. Lol /

_
t
i
;
_

O
, T
O
__
, i = 0, 1, 2, 8 as a hisloiy woio
lho conliacl was pioposoo ano aohoioo lo in all piovious poiioos, wilh H

_
t
i
;
_

O
, T
O
__
,
i = 0, 1, 2, 8 as lho coiiosponoing sol of hisloiios.
4. Slialogios
I misuso nolalion slighlly Ly oolning slialogy funclions :
1
t
_
/
_
t
0
__
: /
_
t
0
_
0, 1 ano
:
A
t
_
/
_
t
0
__
: /
_
t
0
_
0, 1 as lho slialogy funclion foi wholhoi lho impoiloi ano oxpoiloi
pailicipalos in slago gamo t, C
O
t
_
/
_
t
1
__
: /
_
t
1
_
R
+

_
0, j
_

O
t
_
as lho slialogy funclion of
lho impoiloi whon pioposing a conliacl, ano coiiosponoingly
A
t
_
/
_
t
2
__
: /
_
t
2
_
0,
t
ano
T
1
t
_
/
_
t
3
__
: /
_
t
3
_
0, T
t
as lho slialogy funclion of lho oxpoiloi whon oocioing wholhoi
lo mako lho shipmonl, ano lho slialogy funclion of lho impoiloi ooloimining wholhoi sho will
pay.
. Conliacls suppoilaLlo Ly liiggoi slialogios.
42
I lno lho sol of conliacls,
_

O
, T
O
_
, foi which lhoio oxisls suLgamo poifocl oquiliLiia wilh
simplo liiggoi slialogios as oosciiLoo Lolow, lhal will suppoil Lolh pailios aohoiing lo lho
conliacl (lhal is whoio a

t
_

O
, T
O
_
=
_
(1, 1) ,
_

O
, T
O
_
,
O
, T
O
_
will Lo lho oulcomo ovoiy
poiioo). Foi a givon canoioalo conliacl (
O
, T
O
) consiooi lho following liiggoi slialogios, wilh
lho unooislanoing lhal lho sol of hisloiios H

_
t
i
_
, i = 0, 1, 2, 8 coiiospono lo lho sol of hislo-
iios whoio ovoiyLooy has aohoioo lo lhis conliacl (H

_
t
i
;
_

O
, T
O
__
, i = 0, 1, 2, 8):
:
c
t
_
/
_
t
0
__
=
_
1
0
if /
_
t
0
_
H

_
t
0
_
olso
, foi : = 1, A,
C
O
t
_
/
_
t
1
__
=
_
(
O
, T
O
)
( , j ( ))
if /
_
t
1
_
H

_
t
1
_
olso
,

t
_
/
_
t
2
__
=
_
_
_

t
0
if /
_
t
2
_
H

_
t
2
_
if /
_
t
2
_
, H

_
t
2
_
ano cT
t
(1 c) , _ c
olso
,
T
t
_
/
_
t
3
__
=
_
_
_
T
O
T
t
0
if /
_
t
3
_
H

_
t
3
_
if /
_
t
3
_
, H

_
t
3
_
ano T
t
_ ,
if /
_
t
3
_
, H

_
t
3
_
ano T
t
,
,
whoio is lho oplimal shipmonl in a ono shol gamo (as oolnoo in oqualion (2)):
c(j () c

) _ (1 c) (c

,) .
1o show lhal lhoso slialogios aio suLgamo poifocl, I oxploil lho ono-shol oovialion piinciplo,
ano oxamino lho oiloionl suLgamos in oiooi. Consiooi lisl lho oplimalily of T
1
t
_
/
_
t
3
__
. Foi
/
_
t
3
_
H

_
t
3
_
lho conoilion is:
c
2
,
_
1 c
2
_
(j
_

O
_
T
O
) _ (1 c) (T
O
,), (26)
which is conoilion in lho main loxl. Foi /
_
t
3
_
, H

_
t
3
_
lho conoilion foi paymonl:
(cT
O
(1 c) ,) _ T
O
,
which givos lho slialogy funclion T
t
_
/
_
t
3
__
. Consiooi lho oplimalily of
A
t
_
/
_
t
2
__
. Foi
/
_
t
2
_
H

_
t
2
_
lho conoilion is: (T
O
c

)
O
c
2
,
_
1 c
2
_
(T
O
c

) _ 0, which ioquiios:
T
O
_ c

. (27)
Foi /
_
t
2
_
, H

_
t
2
_
lho oplimalily follows fiom lho oiscussion in soclion 8.2. Consiooi lho opli-
malily of C
t
_
/
_
t
1
__
. Foi /
_
t
1
_
H

_
t
1
_
aohoiing lo lho conliacl ioluins:
_
1 c
2
_
1
(j
_

O
_

T
O
)
O
, whoioas oloiing ( , j ( )) is lho Losl alloinalivo which yiolos (j ( ) c) .
_

O
, T
O
_
is
oplimal if:
_
1 c
2
_
1
(j
_

O
_
T
O
)
O
_ (j ( ) c) . (28)
48
Finally foi :
c
t
_
/
_
t
0
__
, : = 1, A. Foi /
_
t
0
_
H

_
t
0
_
, lho conoilions aio, iospoclivoly:
1
1 c
2
_
j
_

O
_
T
O

O
_ 0,
_
T
O
c

O
_ 0,
whoioas foi /
_
t
0
_
, H

_
t
0
_
, lho oplimalily of :
c
t
_
/
_
t
0
__
= 0 follows fiom lho facl lhal lho
olhoi playoi is nol pailicipaling. 1ho oqualions in lho main loxl iofoi lo lho caso whoio lho
impoiloi has all lho Laigaining powoi so T
O
= c

ano conoilion (26) iooucos lo:

c
2
,
_
1 c
2
_
(j
_

O
_
c

) _ (1 c) (c

,),
ano lho conoilion foi lho ono-shol slialogy nol lo Lo oplimal is:
_
1 c
2
_
1
(j
_

O
_
c

)
O
_ (1 c) (j ( ) c) ,
which is salisloo Ly assumplion (1).
8.3 The set of proles supportable by trigger strategies
1his soclion oosciiLos lho sol of paiolo-oplimal oquiliLiia suppoilaLlo Ly liiggoi slialogios as
oosciiLoo aLovo. Il can Lo founo Ly maximizing a woighloo sum of ulilily:
max
q,T
(j () T)

(T c

)
1
,
suLjocl lo lho conoilions oosciiLoo aLovo: (26) ano (27) ano (28). Consiooi lho caso whoio
liaoo is consliainoo (j () o, (o 1) c

), such lhal oqualion (28) musl Lo Linoing. SuLsli-

luling ano maximizing givos:
(o, )
c
2
1 c
2
[j () c

[ = (1 c) (c

,) ,
whoio (o, ) =
[j(q)ooj(q)(1)oj(q)]
[j(q)ooj(q)+j(q)(1)c
2
o[(1)(1c
2
)[[
_ 1 ano (o, 1) = 1, which iooucos
lo oqualion (7) in lho main loxl. Any woighl lo lho oxpoiloi iooucos piolls lo lho impoiloi,
ano lhoioLy lho highosl possiLlo shipmonl.
8.4 The strategies considered in the main text are pareto-optimal
I sook lo piovo lhal lhoio oxisls no suLgamo poifocl oquiliLiium which yiolos highoi piof-
ils foi lho impoiloi lhan lho
_

O
, c

_
consiooioo in lho loxl. Consiooi canoioalo slialogios
(o
1
, o
A
), foi lho impoiloi ano oxpoiloi, iospoclivoly, wilh coiiosponoing oulcomo (
t
, T
t
)
1
t=0
(whoio foi nolalional ioasons I lol lho gamo Lo iopoaloo ovoiy poiioo wilh oiscounl facloi c
2
,
whoio lho slialogy piollo is ioquiioo lo salisfy lho II consliainl foi lho oxpoiloi ano yiolo
44
highoi oiscounloo piolls foi lho impoiloi:

1
t=0
c
2c
(T
t
c

)
t
_ 0 ano

c
2t
[j (
t
) T
t
[
t

1
1c
2
_
j
_

O
_
c

O
.
Consiooi lisl a slialogy lhal ioquiios foi honosl paymonl Ly lho impoiloi in all poiioos:

c=1
c
2c
(j (
t+c
) T
t+c
)
t+c
_ (1 c) (T
t
,)
t
c
2

t+1
(o
1
, o
A
) , foi all t _ 0,
whoio
t+1
is lho punishmonl oosciiLoo fiom lho following poiioo foi lho impoiloi shoulo
sho nol honoi lho paymonl. Sinco nonpailicipalion is possiLlo
t+1
_ 0 foi all t. Cloaily
piosciiLing
t+1
= 0 foi all t is possiLlo ano oplimal, ano a Iaiolo oplimal slialogy piollo
musl havo lhis chaiacloiislic. Sinco lhoio is no IC consliainl foi lho oxpoiloi, il is oplimal lo
sol

1
c=0
c
2c
(T
t+c
c

)
c
= 0 foi all t, such lhal T
t
= c

which givos:

c=1
c
2c
(j (
t+c
) c

)
c
_ (1 c) (c

,)
t
, foi all t _ 0,
Now consiooi lho quanlilios (
c
)
1
c=0
ano somo t ano t
0
foi which:

c=0
c
2c
(j (
t+c
) c

)
t+c


c=0
c
2c
(j (
t
0
+c
) c

)
t
0
+c
. (20)
Consiooi lho caso whoio t t
0
, ano lho alloinalivo quanlilios of (
1
,
2
, ...,
t
0
1
,
t
,
t+1
, ...).
1ho IC consliainls fiom t onwaios oLviously slill holo, ano fiom oqualion (20) lho IC consliainl
foi t
0
1 will Lo losoi ano
t
0
1
can Lo incioasoo. A similai aigumonl can Lo maoo if t < t
0
,
ano only a piollo of conslanl is possiLlo. Honco, lhoio oxisls no suLgamo poifocl oquiliLiium
whoio lho impoiloi aohoios lo lho conliacl ovoiy poiioo lhal oominalos lho ono founo in lho
apponoix. Similai logic can Lo applioo lo show lhal lhoio oxisls no suLgamo poifocl oquiliLiium
in which lho impoiloi novoi aohoios lo lho conliacl, noi ooos so in somo poiioos.
8.5 Appendix unconrmed bank
1his apponoix foimally slalos lho unconlimoo lolloi of ciooil gamo Lolwoon lho oxpoilois,
impoilois, ano lho Lank. 1ho sol of playois in lho full gamo is (1
i
)
c
i=0
, (A
i
)
c
i=0
, 1, , whoio
1
i
ano A
i
coiiospono lo lho impoiloi ano oxpoiloi of paii i, iospoclivoly, ano / is lho Lank. I
lisl oolno lho pailial gamo i, as lho gamo consisling of jusl 1
i
, A
i
, 1 foi somo i, ano show
lhal lho Lank cannol soivo a iolo foi such a gamo.
1. Dolnilion of slago gamo foi lho pailial gamo i (suppioss lho suLsciipl i in lho following).
1ho slago gamo has lhioo playois: impoiloi i, oxpoiloi i, ano a Lank. I splil lho slago gamo
inlo suLslagos, whoio oach coiiospono lo a oocision nolo. Sinco a pail of lho slago gamo
coiiosponos lo lho slago gamo in lho opon accounl, I oislinguish Lolwoon suLslagos t
i
as
oosciiLoo in lho apponoix aLovo, ano t
0
b
coiiosponoing lo lho aooilional suLslagos of lho lolloi
of ciooil. SuLslago t
0
b
: Lank olois opon lolloi conliacl C
b
t
= (
t
, T
t
, 1
t
). SuLslago t
1
b
: Impoiloi
choosos opon accounl conliacl (:
1
t
= O) in which caso lho slago gamo piocooos as oosciiLoo
4
foi lho opon accounl, so suLslagos t
0
, t
1
, t
2
ano t
3
lako placo. Alloinalivoly, sho choosos lho
lolloi of ciooil conliacl (:
1
t
= 1C) in which caso lho gamo piocooos lo suLslago t
2
b
. SuLslago
t
2
b
: Impoiloi oocioos wholhoi lo conlinuo ( :
1
t
= 1) oi nol ( :
1
t
= 0). Simullanoously, oxpoiloi
makos lho samo oocision (wilh coiiosponoing :
A
t
0, 1). Gamo conlinuos only if :
1
t
:
A
t
= 1.
SuLslago t
3
b
: SuLslago t
3
b
: oxpoiloi oocioos on quanlily
A
t
0,
t
. SuLslago t
4
b
: Impoiloi
oocioos wholhoi lo pay (T
1
t
= T
t
1
t
) oi nol (T
1
t
= 0
`
). Lank simullanoously oocioos wholhoi
lo pay (T
b
t
= T
t
) oi nol (T
b
t
= 0).
2. Slago gamo pay-ols
If shipmonl is nol maoo, payol is zoio foi all lhioo playois. If opon accounl is choson,
pay-ol is as oosciiLoo aLovo. If lolloi of ciooil is choson, ano shipmonl is maoo: if Lolh Lank
ano impoiloi pays, pay-ols aio: [j (
t
) (T
t
1
t
)[
t
, (T
t
c

)
t
, ano 1
t

t
, foi impoiloi,
oxpoiloi, ano Lank, iospoclivoly. If impoiloi ooos nol pay, Lul Lank ooos so, oxpocloo ioluin
is j (
t
)
t

c(T
t
1
t
)
t
ano
_

c(1
t
T
t
) T
t
_

t
foi impoiloi ano Lank. If impoiloi pays, Lul
Lank ooos nol, oxpocloo ioluin is ((1
t
T
t
) cT
t
)
t
ano (cT c

)
t
foi Lank ano oxpoiloi,
ano if noilhoi of lhom pay, ioluins aio: j (
t
)
t


c(T
t
1
t
)
t
,
_

c(1
t
T
t
) cT
t
_

t
ano
(cT
t
c

)
t
.
8. Oulcomos
Using lhis, I can oolno an oulcomo of lho slago gamo as a
t
=
_
(
t
, T
t
, 1
t
) , :
1
t
, a
t
,
_
:
1
t
, :
A
t
_
,
A
t
,
_
T
1
t
, T
b
t
__
,
whoio a
t
is lho hisloiy of lho opon accounl slago gamo as il was oosciiLoo aLovo. Fiom lhis I
can oolno hisloiios as:

/
_
t
0
b
_
= (..., a
t4
, a
t2
)

/
_
t
1
b
_
=

/
_
t
0
b
_
'
__

G
t
, T
G
t
, 1
G
t
__

/
_
t
2
b
_
=

/
_
t
1
b
_
' 1C, a
t

/
_
t
3
b
_
=

/
_
t
2
b
_
'
__
:
o
t
, :
j
t
__

/
_
t
4
b
_
=

/
_
t
3
b
_
'
t
,
wilh lho sol of possiLlo hisloiios coiiosponoingly oolnoo as

H
_
t
i
b
_
, foi i = 0, 1, 2, 8, 4. Con-
siooi a givon conliacl
_

G
, T
G
, 1
G
_
, ano oolno lho oulcomo
a

G
, T
G
, 1
G
_
=
__

G
, T
G
, 1
G
_
, :
1
, a

, (1, 1) ,
G
,
_
T
G
1
G
, T
G
__
, :
1
O, 1C as oul-
como of lho slago gamo foi which all aohoio lo lho lolloi of conliacl or lho impoiloi choosos
lho opon accounl liansaclion ano ovoiyLooy aohoios lo lhal, wilh lho opon accounl slago
gamo is lho Losl oulcomo foi lho impoiloi achiovaLlo as a suLgamo poifocl oulcomo oosciiLoo
in lho main loxl: a

=
_
1, 1,
_

O
, c

_
,
O
, c

_
. 1hal is, lho impoiloi choosing opon accounl
is nol consiooioo as a oovialion. Nolo, lhal I can lhon oolno a hisloiy foi which all havo
aohoioo lo lho conliacl

/

_
t
i
b
_
, i = 0, 1, 2, 8, 4, wilh a coiiosponoing sol of all hisloiios of

_
t
i
b
_
, i = 0, 1, 2, 8, 4.
4. Slialogios
In a mannoi similai lo aLovo, I oolno slialogy funclions of C
b
t
:

/
_
t
0
_
R
3
+
, as lho
46
slialogy funclion of lho pioposoo conliacl Ly lho Lank, :
1
t
:

/
_
t
1
0
_
O, 1C, as lho
slialogy funclion of wholhoi lo accopl lho lolloi of ciooil oi insloao pioposo opon accounl,
:
1
t
:

/
_
t
2
0
_
0, 1, :
A
t
:

/
_
t
2
b
_
0, 1, as lho pailicipalion funclion of lho impoiloi ano
oxpoiloi, iospoclivoly,
A
t
:

/
_
t
3
b
_
0,
t
, as lho slialogy funclion of wholhoi lo mako lho
shipmonl, ano T
b
t
:

/
_
t
3
b
_
0, T
t
ano T
1
t
:

/
_
t
3
b
_
0, T
t
1
t
as lho slialogy funclion foi
wholhoi lo honoi paymonl foi lho Lank ano lho impoiloi. 1his concluoos lho oosciiplion of
lho slialogios.
. SuLgamo poifocl of liiggoi slialogios.
Consiooi a givon canoioalo lolloi of ciooil conliacl (
G
, T
G
, 1
G
) wilh lho unooislanoing
lhal

H

_
t
i
b
_
, i = 0, 1, 2, 8, 4 coiiospono lo hisloiios whoio lhis conliacl has Loon honoioo in
all piovious slagos. Consiooi lho slialogios:
C
b
t
_

/
_
t
0
b
_
_
=
_
(
G
, T
G
, 1
G
)
(0, 0, 0)
if

/
_
t
0
b
_


H

_
t
0
b
_
olso
,
:
1
t
_

/
_
t
1
b
_
_
=
_
1C
O
if

/
_
t
1
b
_


H

_
t
1
b
_
olso
,
:
c
t
_

/
_
t
2
b
_
_
=
_
1
0
if

/
_
t
2
b
_


H

_
t
2
b
_
olso
foi : = 1, A,

A
t
_

/
_
t
3
b
_
_
=
_
_
_

t
0
if

/
_
t
3
_


H

_
t
3
_
if

/
_
t
3
b
_
,

H

_
t
3
b
_
ano cT
t
_ c

olso
,
T
1
t
_

/
_
t
4
b
_
_
=
_
1
G
T
G
0
if

/
_
t
4
b
_


H

_
t
4
b
_
olso
,
T
b
t
_

/
_
t
4
b
_
_
=
_
T
G
0
if

/
_
t
4
b
_


H

_
t
4
b
_
olso
,
ano lho opon accounl slialogios as oosciiLoo aLovo, in pailiculai a oovialion fiom lho Lank
implios iovoision lo opon accounl slialogios, Lul a oovialion fiom an impoiloi oi an oxpoiloi
implios no liaoo foiovoi. Nolo lisl, lhal givon lhis slialogy, lho opon accounl slialogios will
Lo oplimal in all suLslagos t
0
, t
1
, t
2
ano t
3
. I chock lho oplimalily of lho slialogios. Consiooi
lisl a hisloiy of

/
_
t
4
b
_
. Foi T
b
t
_
t
4
b
_
, oplimalily foi

/
_
t
4
b
_


H

_
t
4
b
_
ioquiios:
c
2
1 c
2
1
G
_ (1 c) T
G
, (80)
ano il is oasy lo soo lhal nol paying is oplimal foi

/
_
t
4
b
_
,

H

_
t
4
b
_
. Foi T
b
t
_

/
_
t
4
b
_
_
oplimalily
ioquiios foi

/
_
t
4
b
_


H

_
t
4
b
_
:
c
2
1 c
2
_
j
_

G
_

_
1
G
T
G
_
_
_
1

c
_
_
1
G
T
G
_
, (81)
ano lhis hisloiy can only havo Loon ioachoo Ly al loasl ono oovialion Ly lho oxpoiloi oi lho
impoiloi, so nol paying is oplimal.
47
Foi oplimalily of
A
t
_

/
_
t
3
b
_
_
ano

/
_
t
3
b
_


H

_
t
3
b
_
lho ioquiiomonl is
T
G
_ c

, (82)
Whoioas, foi

/
_
t
3
b
_
,

H

_
t
3
b
_
can only Lo ioachoo Ly a oovialion Ly lho impoiloi, so lho
piosciiLoo slialogy is oplimal.
Foi a hisloiy of

/
_
t
2
b
_
, lho oplimalily of :
1
t
_

/
_
t
2
b
_
_
ano :
A
t
_

/
_
t
2
b
_
_
ioquiios T
G
_ c

ano j
_

G
_
_
_
1
G
T
G
_
. Ol-palh, is oplimal Ly consliuclion.
Consiooi C
b
t
_

/
_
t
0
b
_
_
ano :
1
t
_

/
_
t
1
b
_
_
1ho conoilion foi on palh is, iospoclivoly::
_
j
_

G
_

_
1
G
T
G
_

G
_ H
O
, (88)
1
G
_ 0,
ano ol-palh follows oasily.
ComLining oqualions (80) , (82), ano (88) ioluins:
c
2
1 c
2
_
j
G
_

G
_
T
G

G
H
O
_ (1 c)
G
,
which is moio iosliiclivo lhan oqualion 0. 1his oslaLlishos pail ii) of pioposilion 2; Ly jusl
guaianlooing lho shipmonl of ono impoiloi-oxpoiloi paii, lho Lank can Lo of no uso.
The full game
Now, consiooi lho full gamo wilh playois
_
(1
i
)
2
i=0
, (A
i
)
2
i=0
, /
_
, whoio lho oulcomo of oach
pailial gamo is givon Ly a
it
, wilh i [0, 2[, wilh ( a
i,t
)
2
i=0
Loing lho oulcomo of lho onliio
gamo.
29
1hon a hisloiy

/

1
_
t
0
b
_
=
_
..., ( a
i,t2
)
2
i
, ( a
i,t1
)
2
i
_
foi lho full gamo can Lo oolnoo
(wilh

/

1
_
t
i
_
, i = 1, 2, 8, 4 coiiosponoingly oolnoo fiom lhis). Il is lhon sliaighlfoiwaio lo
suLslilulo

/

1
_
t
i
b
_
foi

/

_
t
i
b
_
in lho oosciiplion of slialogios aLovo, ano lno lhal lho only lhing
lhal changos is lho IC consliainl of lho Lank, which Locomos:
c
1 c
_
j
G
_

G
_
T
G

G
H
O
_ (1 c)
G
,
which ioluins oqualions (18) in lho main loxl.
The case in which the IR constraint is not binding
If lho II consliainl is nol Linoing (oqualion (81) Linos Lofoio oqualion (88), lho impoiloi
IC musl Lino, ano suLsliluling givos:
max
q,1
1
1 c
_
1
j 1
j () c

_
,
29
Since each importer-exporter pair is only active every other period, the outcome is ~ o.I = ? for the remaining
periods.
48
suLjocl lo:
Impoiloi IC
c
2
1 c
2
(j () (c

1)) =
_
1

c
_
(c

1) ,
Lank IC:
c
1 c
_
1
j 1
j () c

_
_ (1 c) (c

1) ,
whoio j =
_
1

c
_
_
1 c
2
_
c
2
0, ano il is cloai lhal lho qualilalivo conclusions caiiy
lhiough: 1ho impoiloi IC consliains is lighloi fiom 1 0, ano lho Lank can only soivo a
iolo if

c c, ano lho Lank IC is lighloi, as j 0, ano lho Lank can only soivo a iolo lhiough
moio fioquonl inloiaclion.
8.6 Appendix Mutually conrmed letters of credit
1ho pioLlom is:
max
a,a

,q
L
,q
L
,
(l)

(l

)
1
, (84)
suLjocl lo : _ 1, :

_ c ano:
c
1 c
l _ (1 c) A, (8)
whoio l ano l

aio oolnoo as in lho loxl:

l = :
_
j
_

A
_

A
H
O

c
A
A, (86)
l

= :

_
j
_

A
_

A
H
O

:c

A
A. (87)
Il is oasily oomonslialoo lhal lisl oiooi conoilions foi : ano
A
ioluin:
j
_

A
_

A
= oH
O
,
ano sinco lho nol oulslanoing is fiom homo Lank lo foioign :

= c. Imposing
A
=
1
lhis
ioluins a pioLlom of choosing : ano A so as lo maximizo 84 wil. lo conoilion (8). Il follows
lhal lho IC consliainl is linoai in (A, :) spaco wilh slopo:
(1 c)
1c
c
1
(o 1) H
O
,
ano lho slopo of lho iso-valuo funclion / = l

(l

)
1
is givon Ly:
d:
dA
=

1
(o 1) H
O
rc

1
1 r
,
wilh r = l,l

, which is posilivoly slopoo wilh

o
2
a
o
2
< 0 foi paiamolois wilh inloiioi solulion
(: < 1). Consiooi lisl an incioaso in . 1his will loavo lho IC consliainl unchangoo, Lul
incioasos lho slopo of lho iso-valuo funclion ano Lolh : ano A incioaso. 1his oslaLlishos pail
40
c of pioposilion (8). Iail / is mosl oasily oomonslialoo Ly suLsliluling foi (8) in (84) such
lhal lho pioLlom is an unconsliainoo pioLlom of maximizing wil :. Fiisl oiooi conoilion is:
(1 ,) (o 1) H
O
r(:)
1
(1 )
_
, (o 1) H
O
c

r(:)

= 0,
wilh , =
_
1
c
1c
1
1
_
1
< 1, implying lhal , (o 1) H
O
< c

A
. Using lho onvolopo
lhooiom ano oiloionlialing wil c oomonslialos lhal d:,dc 0, which oslaLlishos pail /.
0