On the design of a credit agreement with peer monitoring

Abstract

This paper analyses the optimal design of collective credit agreements with joint responsibility. First, we demonstrate that these agreements can potentially induce peer monitoring, reduce the incidence of strategic default, and enhance the lender's ability to elicit debt repayments. The resulting benefits in terms of extended credit should, however, be weighted against the higher monitoring effort that such agreements impose upon participant borrowers. Second, we show that the relative benefits from peer monitoring are maximized when risks are positively correlated across borrowers, and also when the size of the group is neither too small (due to a 'joint responsibility', 'cost sharing', and 'commitment' effects) nor too large (due to a 'free riding' effect). Third, we compare among different monitoring structures.