Random monitoring in financing relationships

Abstract

This paper examines a …nancier's optimal monitoring intensity in a multiperiod …nancing relationship. We identify conditions under which the …nancier should sometimes misidentify the quality of an entrepreneur. Such an imperfect evaluation technology a¤ects action choices by bad entrepreneurs. We …rst characterize the optimal monitoring intensity and show that it is one in which the investor monitors entrepreneurs randomly. Random monitoring in the …rst stage of a relationship induces bad entrepreneurs to reveal their intrinsic types. Second, because random monitoring reduces the share of bad entrepreneurs in the subsequent periods, we show that the …nancier can therefore realize substantial gains.