The Socially Optimal Loan Auditing with Multiple Projects

This paper fills the gap in the literature by introducing an efficient, incentive compatible audit policy that can minimise the social loss created by the audit cost while maximising social welfare. We apply this within a loan auditing context, but the method is also applicable to any accounting and tax audit context. We explain why the loan contract design for finance of projects varies between different situations. Each project outcome is random and private information of its individual owner, but reported outcomes can be audited at a cost. Our framework simultaneously determines incentive compatible auditing policies, interest rates and default probabilities to yield an efficient contract design. We show how the socially best loan audit policy and repayments depend on the degrees of information asymmetry and risk correlation between projects, the number of agents in the agreement and the agents’ perception of loan default.