Question 2. Consider a risk-neutral no-discounting environment. Firms have projects
requiring one unit of investment and yielding y with probability p and 0 otherwise. If the
project succeeds, the firm can invest another unit in a similar project in the following period.
Before providing a loan, banks have to incur, once and for all, a sunk cost y for collecting
info about the firm. Once this investment is made, the bank is able to grant future loans to
the same firm without any additional cost-benefit of maintaining a continued relationship
with the same bank.
Answer the following questions:
1. (1 point) If there are two periods, is it beneficial for a firm to enter relationship
banking? Explain your answer.
2. (5.5 points) Suppose that there are three periods. If a firm and a competive bank
enter relationship banking for three periods, what will be the interest rates charged
for each period? Explain your answer.
3. (1 point) In the case of three periods, should a firm enter three-period relationship
banking, two-period relationship banking (starting from the first period or second
period), or no relationship banking at all? Explain your answer.
