Optimal Monitoring of Long-Term Loan Contracts

Abstract

This paper presents a theoretical model of the monitoring behaviour of a bank-intermediated financial system with a rolling portfolio of long-term loans. The projects funded by the loans are subject to persistent idiosyncratic shocks that are freely observed by the borrowers. Borrowers pay entry costs in order to produce and liquidation costs to exit and therefore are willing to pay a higher interest rate for greater security of funding. However, they also have limited liability and will make continuation choices that shift risk to the bank in the absence of monitoring. To limit its exposure to risk, the bank applies a continuation threshold of its own, labeled a covenant. The bank has an incentive to acquire information both to enforce the covenant in the current period and update its monitoring intensity in future periods. But information is costly to acquire and reduces the value of the loan contract to the borrower because it passes more of the continuation right to the bank and therefore lowers the equilibrium interest rate. The paper uses numerical methods to calculate the optimal monitoring rate and covenant threshold as well as the associated loan interest rate and default rate.