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Costly State Verification with Varying Risk Preferences and Liability

Garino, G. and Simmons, P. (2006) Costly State Verification with Varying Risk Preferences and Liability. Journal of Economic Surveys, 20 (1). pp. 71-110. ISSN 0950-0804

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In the scenario of loan contracts with costly state verification, we examine how the properties of the set of states, different risk preferences of debtors and varying liability of lenders affect the structure of optimal repayments. In particular, we show that with risk‐averse debtors, a general set of states, a constant observation cost and both unlimited and limited lender liability, the debtor is strictly better off revealing the true state of nature when his realized revenue is low, which implies that optimal debtor consumption has a downward jump around the single switch from observed to unobserved states. If the debtor can destroy revenue or if the debtor is risk neutral, this non‐monotonicity of consumption disappears. Moreover, given the loan size, there is more monitoring under debtor‐risk aversion than risk neutrality. We present simulations showing that a contract with unlimited lender liability and debtor‐risk aversion has a higher expected observation cost but a lower variance of consumption than a contract with limited lender liability. Finally, we discuss the problems of commitment to verification and contract renegotiation in this framework.

Item Type: Article
Institution: The University of York
Academic Units: The University of York > Economics and Related Studies (York)
Depositing User: York RAE Import
Date Deposited: 04 May 2009 16:01
Last Modified: 04 May 2009 16:01
Published Version: http://dx.doi.org/10.1111/j.0950-0804.2006.00276.x
Status: Published
Publisher: Blackwell Publishing Ltd
Identification Number: 10.1111/j.0950-0804.2006.00276.x
URI: http://eprints.whiterose.ac.uk/id/eprint/6521

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