Debt Contract, Strategic Default, and Optimal Penalties with Judgement Errors

We characterize the competitive equilibrium on the credit market when borrowers can strategically default. We assume that the audit is subject of errors of the two types and that lenders cannot commit ex-ante. We determine the penalty, the loan rate, the audit and strategic default probabilities. Borrowers' limited liability is endogenous when "judicial errors" exist, strategic default appears at equilibrium depending on the borrowers' absolute risk aversion. We show that at equilibrium loan contracts exhibit a penalty such that borrowers never strategically default. This is true with IARA and CARA utility function. Finally, we show that with DARA, strategic default may exist.