On the design of a credit agreement with peer monitoring

This paper analyses the optimal design of collective credit agreements with joint responsibility. First, we demonstrate that these agreements can pote ntially induce peer monitoring, reduce the incidence of strategic default, and enhance the lender's ability to elicit debt repayments. The resulting b enefits in terms of extended credit should, however, be weighted against th e higher monitoring effort that such agreements impose upon participant bor rowers. 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 responsibi lity", "cost sharing", and "commitment" effects) nor too large (due to a "f ree riding" effect). Third, we compare among different monitoring structure s. (C) 1999 Elsevier Science B.V. All rights reserved.