Retained Earnings, Interest Rates and Lending Relationship

This paper provides a moral hazard characterization of the effects of lending relationship on cost of funds. I develop a model that studies the problem of financial contracting between a bank and an entrepreneur and isolates the effect of the lending relationship on the interest rates. The main result is that a bank-entrepreneur relationship has a positive effect on the interest rates, the optimal contract specifying a decreasing sequence of interest rates. The possibility of the entrepreneur to use partially his retained earnings improves the terms of the contract between entrepreneur and lender by reducing the difference between the two interest rates.