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

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  • Jain, N.
  • Imai, S.

Abstract

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.

Suggested Citation

  • Jain, N. & Imai, S., 2015. "Dynamic Costly State Verification with Repeated Loans: a two-period analysis," Working Papers 13889, Department of Economics, City University London.
  • Handle: RePEc:cty:dpaper:13889
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    File URL: https://openaccess.city.ac.uk/id/eprint/13889/1/Jain%20-%20Economics-DP-15-17.pdf
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    References listed on IDEAS

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    1. Smith, Bruce D. & Wang, Cheng, 1998. "Repeated insurance relationships in a costly state verification model: With an application to deposit insurance," Journal of Monetary Economics, Elsevier, vol. 42(2), pages 207-240, July.
    2. Ludovic Renou, 2008. "Multi-lender coalitions in costly state verification models," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 36(3), pages 407-433, September.
    3. Cyril Monnet & Erwan Quintin, 2005. "Optimal contracts in a dynamic costly state verification model," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 26(4), pages 867-885, November.
    4. Townsend, Robert M., 1979. "Optimal contracts and competitive markets with costly state verification," Journal of Economic Theory, Elsevier, vol. 21(2), pages 265-293, October.
    5. Douglas Gale & Martin Hellwig, 1985. "Incentive-Compatible Debt Contracts: The One-Period Problem," Review of Economic Studies, Oxford University Press, vol. 52(4), pages 647-663.
    6. Chang, Chun, 1990. "The dynamic structure of optimal debt contracts," Journal of Economic Theory, Elsevier, vol. 52(1), pages 68-86, October.
    7. Bolton, Patrick & Scharfstein, David S, 1990. "A Theory of Predation Based on Agency Problems in Financial Contracting," American Economic Review, American Economic Association, vol. 80(1), pages 93-106, March.
    8. David C. Webb, 1992. "Two-Period Financial Contracts with Private Information and Costly State Verification," The Quarterly Journal of Economics, Oxford University Press, vol. 107(3), pages 1113-1123.
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    Cited by:

    1. Smith, Bruce D. & Wang, Cheng, 1998. "Repeated insurance relationships in a costly state verification model: With an application to deposit insurance," Journal of Monetary Economics, Elsevier, vol. 42(2), pages 207-240, July.

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