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

Proof – The Claim follows immediately from (3) — the entrepreneur’s optimal risk is determined by

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

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