Costly state verification

Costly state verification (CSV) is a framework in contract theory that studies how to design financial contracts when verifying the performance of a borrower is expensive. In this setting, a lender or investor must incur a cost to monitor or audit the actual outcome of a project undertaken by a borrower or entrepreneur. The key challenge is to design a contract that provides the right incentives while minimizing these verification costs.

A central result of the CSV approach, introduced by Robert M. Townsend (1979), is that under certain assumptions, the optimal contract is a standard debt contract. In this contract, there is no disclosure of the entrepreneur's performance as long as debt payments are made. However, if the borrower defaults, the lender pays to verify the actual outcome. This leads to a state-contingent disclosure rule, where verification occurs only in the event of default. Viewed from this perspective, the main role of bankruptcy institutions is to enforce these contracts by verifying and disclosing the assets and liabilities of the firm and establishing its net value during default.