Working Paper: CEPR ID: DP6040
Authors: Hans Krogh Hvide; Tore Leite
Abstract: 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
JEL Codes: D02; D82; G21; G33
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| costly enforcement and stochastic monitoring (K40) | debt emerges as the optimal contract (D86) |
| optimal debt contract (H63) | induces creditor leniency (G33) |
| optimal debt contract (H63) | allows for strategic defaults by the borrower (G33) |
| borrower defaults strategically (G33) | probability of verification dependent on repayment offer (D81) |
| optimal debt contract (H63) | strategic defaults and absolute priority violations observed in practice (G33) |