Optimal Debt Contracts Under Costly Enforcement
25 Pages Posted: 18 Aug 2005 Last revised: 22 Apr 2015
Date Written: April 15, 2008
We consider a financing game with costly enforcement based on Townsend (1979), but where monitoring is non-contractible and allowed to be stochastic. Debt is the optimal contract. Moreover, the debt contract induces creditor leniency and strategic defaults by the borrower on the equilibrium path, consistent with empirical evidence on repayment and monitoring behavior in credit markets.
Keywords: Costly state verification, debt contract, priority violation, strategic defaults
JEL Classification: D02, D82, G21, G33
Suggested Citation: Suggested Citation