Dynamic Costly State Verification with Repeated Loans: a two-period analysis

We derive the optimal contract in a two period costly state verification model with repeated loans, where in each period, the borrower invests in an identical project. We allow the borrower to switch lenders at the end of the first period. We show that while the second period optimal contract continues to be a standard debt contract, the optimal contract for the first project need not be. Regardless of the form of the first period contract, there is less monitoring in the first period and total monitoring costs are strictly lower, relative to a sequence of short term contracts. We illustrate our results assuming a uniform distribution for firm revenue and fixed monitoring costs. In particular, we show that either there is no monitoring in the first period or maximum possible amount consistent with the outside option is collected in the second period.