DP6040 Optimal Debt Contracts under Costly Enforcement

Author(s): Hans K Hvide, Tore Leite
Publication Date: January 2007
Keyword(s): Costly state verification, debt contract, priority violation, strategic defaults
JEL(s): D02, D82, G21, G33
Programme Areas: Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=6040

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.