Hence, riskier projects that turned out to be successful are associated with higher output. Entrepreneurs must finance the investment H by bank credit, at a real interest cost of r,. The expected gross income from project type x, denoted by к, is
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Proof – The Claim follows immediately from (3) — the entrepreneur’s optimal risk is determined by
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Had the project been self financed, the entrepreneur’s optimal risk would be determined by ^(M)] _ Q For example, if 9 = 1, entrepreneurs choose д = ^+ (1+^)Я.; д denoting the entrepreneur’s optimal risk. In these circumstances, a risk neutral entrepreneur who self finances the project would choose /*’ = “ Figure 1 summarizes the entrepreneur’s behavior, drawn for the case where H = 1. Curve mt corresponds to the expected gross income, ж(д). Curve cc is the expected financing cost, (1-д)(1 + гг). Point В determines the optimal risk undertaking from the entrepreneurs point of view, whereas point D is the optimal risk undertaking if the project is self financed.

Banks may engage in costly risk monitoring. Specifically, spending z per project allows the bank to verify that the project’s probability of failure is Д. We assume that the monitoring cost increases with risk reduction
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where rc is the bank’s cost of funds. Henceforth, we assume a non prohibitive cost of monitoring — i.e., banks are better off monitoring.5 Each bank controls a large number of independent projects, diversifying away the idiosyncratic risk. Competition among banks induces rent dissipation. payday loan lenders