Scandinavian Working Papers in Economics

Discussion Papers,
Norwegian School of Economics, Department of Business and Management Science

No 2005/4: Optimal contracts under imperfect enforcement revisited

Hans K. Hvide ()
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Hans K. Hvide: Dept. of Finance and Management Science, Norwegian School of Economics and Business Administration, Postal: NHH , Department of Finance and Management Science, Helleveien 30, N-5045 Bergen, Norway

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 behavior in credit markets.

Keywords: Costly state verification; debt contract; priority violation; strategic defaults

JEL-codes: D02; D82; G21; G33

21 pages, September 12, 2005

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