Lending, Lying, and Costly Auditing

In this paper, we describe a bankruptcy game played in a pure-exchange, perfectly competitive economy, and establish the existence of competitive equilibria. The game admits of lying by borrowers and costly auditing by lenders. The equilibria are characterized by (endogenously determined) equilibrium probabilities of default, loan quantities, interest rates, and default risk premia, and by equilibria simultaneously determined in risk-free debt markets. We find that the optimal debt contract is the standard debt contract, and that the risk-free debt market may be inactive, as all parties may strictly prefer risky debt contracts to risk-free debt.