Costly monitoring, dynamic incentives, and default

Abstract

We study dynamic contracts between a lender and a borrower in the presence of costly state verification and hidden effort. The optimal contract minimizes social losses by mediating dynamic incentives and monitoring. Along the efficiency frontier, the threat of early termination is unavoidable for low levels of the borrower's promised utility; as the level increases, preventive monitoring is used to avoid future inefficient termination of the contractual relationship due to asymmetric information; for high level of promised utility, the threat of termination of the contractual relationship is no longer a useful tool to align dynamic incentives, preventive monitoring loses its role, and termination never occurs. Thus, the efficient contract optimizes the tradeoff between dymanic incentievs and static incentives. Following the interpretaion of the costly state verification literature, we can distinguish two levels of bankruptcy: one that leads to monitoring and the other that leads to liquidation.

Should the Timing of Inspections be Predictable?

“…To solve for the optimal inspection policy in our model, we explicitly consider 5 Most subsequent work on dynamic contracts analyzes monitoring of current actions; see Antinolfi and Carli (2015); Piskorski and Westerfield (2016); Chen et al (2020); Li and Yang (2020); Dai et al (2022); Rodivilov (2022); Wong (2022). In Halac and Prat (2016) and Dilmé and Garrett (2019), the principal's investment has a persistent effect on her monitoring capabilities, but monitoring still reveals information about current actions only.…”

Contingent Debt and Performance Pricing in an Optimal Capital Structure Model with Financial Distress and Reorganization

“…Our paper complements these studies, as we obtain contingent debt and bankruptcy reorganization as a part of an optimal contract trading o¤ agency and monitoring costs. This paper is also related to the large literature on optimal contracts with information frictions and costly monitoring, which goes back to Townsend (1979) and Gale and Hellwig (1985) in static settings and includes dynamic analyses of Monnet and Quintin (2005), Wang (2005), Antinol… and Carli (2015), , and Varas et al (2017), among others. The innovation of our model is to add a search friction in the spirit of Mortensen and Pissarides (1994) and Du¢ e et al (2005).…”

Relational enforcement

“…88 For dynamic moral‐hazard problems in which monitoring reveals the current action, see Antinolfi and Carli (2015), Piskorski and Westerfield (2016), Dilmé and Garrett (2019), Chen, Sun, and Xiao (2020), Li and Yang (2020), Dai, Wang, and Yang (2022), Wong (2022). For dynamic adverse‐selection problems in which verification reveals the agent's current information that is independent and identically distributed (i.i.d.)…”