Costly State Verification with Varying Risk Preferences and Liability

40 Pages Posted: 8 May 2006

See all articles by Gaia Garino

Gaia Garino

University of Leicester - Department of Economics

Peter J. Simmons

University of York - Department of Economics and Related Studies

Abstract

In the scenario of loan contracts with costly state verification, we examine how the properties of the set of states, different risk preferences of debtors and varying liability of lenders affect the structure of optimal repayments. In particular, we show that with risk-averse debtors, a general set of states, a constant observation cost and both unlimited and limited lender liability, the debtor is strictly better off revealing the true state of nature when his realized revenue is low, which implies that optimal debtor consumption has a downward jump around the single switch from observed to unobserved states. If the debtor can destroy revenue or if the debtor is risk neutral, this non-monotonicity of consumption disappears. Moreover, given the loan size, there is more monitoring under debtor-risk aversion than risk neutrality. We present simulations showing that a contract with unlimited lender liability and debtor-risk aversion has a higher expected observation cost but a lower variance of consumption than a contract with limited lender liability. Finally, we discuss the problems of commitment to verification and contract renegotiation in this framework.

Suggested Citation

Garino, Gaia and Simmons, Peter J., Costly State Verification with Varying Risk Preferences and Liability. Journal of Economic Surveys, Vol. 20, No. 1, pp. 71-110, February 2006, Available at SSRN: https://ssrn.com/abstract=886615 or http://dx.doi.org/10.1111/j.0950-0804.2006.00276.x

Gaia Garino (Contact Author)

University of Leicester - Department of Economics ( email )

Department of Economics
Leicester LE1 7RH, Leicestershire LE1 7RH
United Kingdom

Peter J. Simmons

University of York - Department of Economics and Related Studies ( email )

Heslington
York, YO1 5DD
United Kingdom

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