This paper by Douglas W. Diamond examines the dynamics of incentive problems between borrowers and lenders in debt markets, focusing on how reputation formation and the evolution of incentive effects over time mitigate conflicts of interest. The main finding is that incentive problems are most severe for borrowers with short track records and become less severe for those who acquire a good reputation. The paper models reputation as arising from learning about exogenous characteristics of agents over time, and it analyzes the joint influence of adverse selection and moral hazard on the ability of reputation to eliminate conflicts of interest. If there is significant adverse selection initially, reputation effects may not be strong enough to improve incentives for borrowers with short track records. However, over time, a good reputation can become strong enough to eliminate conflicts of interest for borrowers with a long record of repayment without default. The paper also discusses the implications for markets where reputation takes time to work, such as the use of restrictive covenants and additional monitoring by financial intermediaries.This paper by Douglas W. Diamond examines the dynamics of incentive problems between borrowers and lenders in debt markets, focusing on how reputation formation and the evolution of incentive effects over time mitigate conflicts of interest. The main finding is that incentive problems are most severe for borrowers with short track records and become less severe for those who acquire a good reputation. The paper models reputation as arising from learning about exogenous characteristics of agents over time, and it analyzes the joint influence of adverse selection and moral hazard on the ability of reputation to eliminate conflicts of interest. If there is significant adverse selection initially, reputation effects may not be strong enough to improve incentives for borrowers with short track records. However, over time, a good reputation can become strong enough to eliminate conflicts of interest for borrowers with a long record of repayment without default. The paper also discusses the implications for markets where reputation takes time to work, such as the use of restrictive covenants and additional monitoring by financial intermediaries.