Costly State Verification: The Choice Between Ex Ante and Ex Post Verification Mechanisms

For financial contracting with costly state verification, it is shown that arrangements involving an ex ante commitment to monitoring regardless of returns tend to dominate if the borrower's initial wealth is small and the investment outlay is large, arrangements involving conditioning of monitoring on returns tend to dominate if the borrower's initial wealth is large and the investment outlay is small. The result hinges on either decreasing absolute risk aversion of the borrower or the desire to exploit opportunities for reducing expected monitoring costs by decreasing the probability of monitoring.