Reputation and constructive ambiguity in financial contracting

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Creator Series Date Created
  • 1991-05
Abstract
  • We explain why contracting parties may choose ambiguous financial contracts. Introducing ambiguity may be optimal, even when unambiguous contracts can be costlessly written. We show that an ambiguous contract has two advantages. First, it permits the guarantor to sacrifice reputational capital in order to preserve financial capital as well as information reusability in states where such tradeoff is optimal. Second, it fosters the development of reputation. This theory is then used to explain ambiguity in mutual fund contracts, bank loan commitments, bank holding company relationships, the investment banker's "highly confident" letter, non-recourse debt contracts in project financing, and other financial contracts.

Subject (JEL) Date Modified
  • 08/21/2018
Corporate Author
  • Federal Reserve Bank of Minneapolis. Research Department.
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