This paper determines when a debt contract will be monitored by lenders. This is the choice between borrowing directly (issuing a bond, without monitoring) and borrowing through a bank that monitors to alleviate moral hazard. This provides a theory of bank loan demand and of the role of monitoring in circumstances in which reputation effects are important. A key result is that borrowers with credit ratings toward the middle of the spectrum rely on bank loans, and in periods of high interest rates or low future profitability, higher-rated borrowers choose to borrow from banks.

We analyze the efficiency and market equilibirum effects of endogenous categorization, where insurance companies classify risks on the basis of insureds' voluntary consumption of products that are correlated with underlying loss propersities, and we show that the use of such categorization may permit the attainment of first-best allocations as competitive Nash equilibria. The optimal insurance premium involves a trade-off between the use of categorization to correct moral hazard externalities generated by the consumption of the product and the use of differential consumption to sort heterogeneous consumers, thereby mitigating the social costs of adverse selection. The efficiency consequences of taxing or subsidizing aggregate, as opposed to individual, consumption is also considered.

This paper determines when a debt contract will be monitored by lenders. This is the choice between borrowing directly (issuing a bond, without monitoring) and borrowing through a bank that monitors to alleviate moral hazard. This provides a theory of bank loan demand and of the role of monitoring in circumstances in which reputation effects are important. A key result is that borrowers with credit ratings toward the middle of the spectrum rely on bank loans, and in periods of high interest rates or low future profitability, higher-rated borrowers choose to borrow from banks.

We analyze the efficiency and market equilibirum effects of endogenous categorization, where insurance companies classify risks on the basis of insureds' voluntary consumption of products that are correlated with underlying loss propersities, and we show that the use of such categorization may permit the attainment of first-best allocations as competitive Nash equilibria. The optimal insurance premium involves a trade-off between the use of categorization to correct moral hazard externalities generated by the consumption of the product and the use of differential consumption to sort heterogeneous consumers, thereby mitigating the social costs of adverse selection. The efficiency consequences of taxing or subsidizing aggregate, as opposed to individual, consumption is also considered.