{{inline, date=December 2022 Costly State Verification (CSV) is an approach in

contract theory From a legal point of view, a contract is an institutional arrangement for the way in which resources flow, which defines the various relationships between the parties to a transaction or limits the rights and obligations of the parties. From an ...

that considers a contract design problem in which verification (or disclosure) of enterprise performance is costly and a lender has to pay a monitoring cost. A central result of CSV approach is that it is generally optimal to commit to a partial, state-contingent disclosure rule.

Robert M. Townsend Robert Morris Townsend (born April 23, 1948) is an American economist and professor; he is the Elizabeth & James Killian Professor of Economics at Massachusetts Institute of Technology. Prior to joining MIT, he was the Charles E. Merriam Disti ...

(1979) has shown that under few strong assumptions the optimal financing mechanism is a standard debt contract for which there is no disclosure of the debtor's performance as long as debt is honored, but there is full disclosure (

verification Verify or verification may refer to: General * Verification and validation, in engineering or quality management systems, is the act of reviewing, inspecting or testing, in order to establish and document that a product, service or system meets ...

) in case of default. Viewed from the CSV perspective, the main function of bankruptcy institutions is to establish a clear inventory of all

assets and liabilities Asset and liability management (often abbreviated ALM) is the practice of managing financial risks that arise due to mismatches between the assets and liabilities as part of an investment strategy in financial accounting. ALM sits between ri ...

and to assess the

net value Net or net may refer to: Mathematics and physics * Net (mathematics), a filter-like topological generalization of a sequence * Net, a linear system of divisors of dimension 2 * Net (polyhedron), an arrangement of polygons that can be folded u ...

of the firm. The standard setup for financial contracting problems in CSV framework involves two

risk-neutral In economics and finance, risk neutral preferences are preferences that are neither risk averse nor risk seeking. A risk neutral party's decisions are not affected by the degree of uncertainty in a set of outcomes, so a risk neutral party is in ...

agents, a wealth-constrained entrepreneur with an investment project, and a wealthy investor with capital available. The

fixed capital In accounting, fixed capital is any kind of real, physical asset that is used repeatedly in the production of a product. In economics, fixed capital is a type of capital good that as a real, physical asset is used as a means of production which ...

invested in the project generates random

cash flow A cash flow is a real or virtual movement of money: *a cash flow in its narrow sense is a payment (in a currency), especially from one central bank account to another; the term 'cash flow' is mostly used to describe payments that are expected ...

at future time ''t'' with probability distribution over the possible range of profits. The

entrepreneur Entrepreneurship is the creation or extraction of economic value. With this definition, entrepreneurship is viewed as change, generally entailing risk beyond what is normally encountered in starting a business, which may include other values t ...

has private

information Information is an abstract concept that refers to that which has the power to inform. At the most fundamental level information pertains to the interpretation of that which may be sensed. Any natural process that is not completely random, ...

about realized

cash flows A cash flow is a real or virtual movement of money: *a cash flow in its narrow sense is a payment (in a currency), especially from one central bank account to another; the term 'cash flow' is mostly used to describe payments that are expected ...

from the project, but it can credibly disclose them to the investor by incurring certain cost. The solution to this problem should provide

ex-ante The term ''ex-ante'' (sometimes written ''ex ante'' or ''exante'') is a phrase meaning "before the event". Ex-ante or notional demand refers to the desire for goods and services that is not backed by the ability to pay for those goods and servic ...

optimal contract structure which specify in which scenario realized cash flow should be

audited An audit is an "independent examination of financial information of any entity, whether profit oriented or not, irrespective of its size or legal form when such an examination is conducted with a view to express an opinion thereon.” Auditing ...

and

certified Certification is the provision by an independent body of written assurance (a certificate) that the product, service or system in question meets specific requirements. It is the formal attestation or confirmation of certain characteristics of a ...

. With no audit the entrepreneur would never be able to raise any money from investor since rational investor anticipates that the entrepreneur will lie about realized profit to avoid paying back to the investor. However, in CSV framework regulated mandatory periodic disclosure of entrepreneurial performance is not efficient and imposes excessive disclosure costs. The optimal financial contract in CSV model gives the creditor the right to all assets of the project in the event of default at fixed bankruptcy cost that must be incurred to collect the proceeds. The results that standard debt contract is optimal does not hold in case of multiple investors or multiple risky projects undertaken by the entrepreneur.

References

*Townsend, R.M., 1979. Optimal contracts and competitive markets with costly state verification. Journal of Economic Theory 21(2), 265–293. *Gale, Douglas and Hellwig, Martin (1985), "Incentive-Compatible Debt Contracts I: The One-Period Problem", Review of Economic Studies 52, 647-64 *Bolton, Patrick and Dewatripont, Mathias. Contract Theory. MIT Press, 2005. Game theory Asymmetric information

See also

References