Discussion paper

DP6040 Optimal Debt Contracts under Costly Enforcement

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.


Hvide, H and T Leite (2007), ‘DP6040 Optimal Debt Contracts under Costly Enforcement‘, CEPR Discussion Paper No. 6040. CEPR Press, Paris & London. https://cepr.org/publications/dp6040