Efficient audits by pooling independent projects: Separation vs. conglomeration

Within a costly state verification model with endogenous audit and commitment, the paper proposes a rationale for joint financing based on the reduction of audit costs. Joint financing dominates separate financing when the incentive effects brought about by optimally chosen variable intensity audits, with the worst outcomes audited intensively and the intermediate ones residually, outweigh the cost of joint financing. This is represented by the extra-deadweight loss due to the unnecessary audit that a successful project may undergo when jointly financed. The result always holds when joint financing involves coinsurance gains -a successful project bails out a failing onebut may also hold under contagion -a succeeding project is dragged down by a failing one. Moreover, it is robust to the sequencing of audits. The paper derives a number of testable predictions relating the emergence of joint financing to project returns, investment cost, bankruptcy costs, quality of accounting standards and timing of audits.