Abstract
In this chapter, Kenneth Ayotte and Patrick Bolton model the role that mandatory standardization plays in reducing the costs of financial contracting and improving liquidity. In particular, they identify opportunities for financial contractors to appropriate value from unknowing third parties and show that rules that standardize contracts can serve as a commitment device against such demand-dampening pitfalls facing these other parties. Mandatory standardization thereby can improve the liquidity of secondary markets from loan contracts. The model also has implications for the current financial crisis. In good times such as an asset bubble, secondary purchasers of loan contracts will not be as scared off by the weakened covenants in loan contracts, because the costs of the moral hazard created by such "covenant lite" contracting will only hurt purchasers in bad states. This equilibrium in good states can turn into one with pervasive "lemon problems" when the bubble bursts and times are bad.