The Loan Contract with Costly State Verification and Subjective Beliefs

We provide a \r\n characterization of the optimal loan contract with costly state verification\r\nfor the bank when the entrepreneur is risk averse and holds a belief \r\ndifferent from that of the bank.\r\n\r\nWhile the optimality problem is formally infinite dimensional, under realistic assumptions it becomes finite dimensional. We provide\r\nconditions and examples to show that when the borrower is more\r\noptimistic than the bank, there may be only one verification region. \r\n\r\nA simple example, based on Bernanke and Gertler (1989), shows\r\nthat as the borrower becomes more optimistic the financial\r\naccelerator (Bernanke et al., 1999) becomes more\r\npotent.