Conditionality and fragility in long-term financial contracts

Abstract

Lenders condition future loans on some index of past performance. Typically, banks condition future loans on repayments of earlier obligations while international organizations condition future loans on the implementation of some policy conditions. We build an agency model that accounts for these tendencies to offer an explanation for why both types of conditionality clause may coexist. The optimal conditionality clause depends on the likelihood that a borrower who has been denied funds from the original lender can access funds from other sources, what we call ‘fragility’. For conditionality to work it is paramount that when lenders deny future loans borrowers do not have access to alternative sources of funds. When fragility is not a major issue conditional on investment contracts are optimal. In contrast, when fragility is a major concern then conditional on repayment contracts are optimal as they reduce the likelihood of those states where fragility becomes an issue.