Optimal Debt Contracts Under Costly Enforcement
26 Pages Posted: 27 Jun 2007
Date Written: January 2007
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 behaviour in credit markets.
Keywords: Costly state verification, debt contract, priority violation, strategic defaults
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