Financial Contracting with Enforcement Externalities

Financial markets crucially rely on the development of an infrastructure dedicated to the enforcement of contracts. Here we study the effects of limited enforcement capacity on financial contracting by proposing a new theory of costly state verification. In our model the principal contracts with a population of entrepreneurs, who borrow to finance risky projects under limited liability. To sustain incentives to repay debt, the principal must build enforcement capacity ex ante, which determines state verification efforts ex post. Our theory sheds new light on such phenomena as credit crunches and the link between enforcement infrastructure accumulation, economic growth and political economy frictions.