This question assumes the following timing. First a loan is made.

Then returns are received. Next, monitoring is undertaken to assess the nature of the returns. Finally a report is made based on the monitoring.

In this setting, a bank would like to extend loans to a population of identical borrowers. The bank knows that any borrower in this economy can invest an amount I and get a gross return of y with certainty.

But the bank is unable to verify the borrowers’ return realizations.

The gross interest rate on a loan is R. When a project yields a return, a borrower can either repay R or lie. If the borrower lies, she will incur a sanction B. Explain what happens when B < R. Now suppose that the bank lends to a group of two borrowers under a “joint responsibility default clause” and suppose that the borrowers can monitor and verify each other’s return realizations when either borrower states that she cannot repay. Monitoring return realizations costs k < B < R. Assume that y > 2R. Can potential borrowers obtain a loan in this case? Relate your answer to your own interpretation of B.