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Strategic default and optimal audit resources with costly state verification

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  • Krause, Andreas

Abstract

I develop a model in which the ability to repay a loan is private information that can only be verified by the bank at some costs, which can be recovered from the borrower if it has reported untruthfully. The bank will optimize the resources it spends on this auditing of borrowers and the resulting equilibrium is then characterized. It is shown that in equilibrium, a significant fraction of companies default strategically, but most are captured via auditing. The failure rates of banks are also small. Finally extensions are discussed to include limited liability to banks and the partial recovery of auditing costs as well as punitive costs to borrowers.

Suggested Citation

  • Krause, Andreas, 2022. "Strategic default and optimal audit resources with costly state verification," Research in Economics, Elsevier, vol. 76(4), pages 413-421.
    • Handle: RePEc:eee:reecon:v:76:y:2022:i:4:p:413-421
    DOI: 10.1016/j.rie.2022.09.005
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    References listed on IDEAS

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    3. Pavan, Marina & Barreda-Tarrazona, Iván, 2020. "Should I default on my mortgage even if I can pay? Experimental evidence," Journal of Economic Dynamics and Control, Elsevier, vol. 110(C).
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    More about this item

    Keywords

    Strategic default; Costly state verification; Audit resources; Loan repayments;
    All these keywords.

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • D53 - Microeconomics - - General Equilibrium and Disequilibrium - - - Financial Markets
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • C72 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Noncooperative Games

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