The Review of Economic Studies · 1995 · 1.1K citations · 0 references
Unprofitable projects may continue to be financed when sunk costs are incurred, a situation relevant to soft budget constraints in centralized economies and differing Anglo‑Saxon versus German‑Japanese financing practices. The study investigates how credit decentralization can prevent refinancing of low‑quality projects, thereby discouraging entrepreneurs from initiating them. The authors analyze a credit model in which adverse selection allows unprofitable projects to be financed. Decentralization provides financial discipline but imposes an excessive premium on short‑term returns.
We study a credit model where, because of adverse selection, unprofitable projects may nevertheless be financed. Indeed they may continue to be financed even when shown to be low-quality if sunk costs have already been incurred. We show that credit decentralization offers a way for creditors to commit not to refinance such projects, thereby discouraging entrepreneurs from undertaking them initially. Thus, decentralization provides financial discipline. Nevertheless, we argue that it puts too high a premium on short-term returns. The model seems pertinent to two issues: “soft budget constraint” problems in centralized economies, and differences between “Anglo-Saxon” and “German-Japanese” financing practices.