Nobel Lecture: Financial Intermediaries and Financial Crises.

The investors will only know how much the bank repays them, not the actual amount the borrower could pay to the bank. The optimal contract between the bank and investors (in this context, depositors) to provide incentives for delegated monitoring is a debt contract issued by the bank promising to pay the depositors. Townsend ([50]) assumes contractual commitment to judicial verification of the borrower's cash after a default, reducing borrower payoffs to zero, and subtracting a fixed cost from total investor payoffs. Investors and borrowers are risk neutral, but borrowers have no funds of their own, and each investor's spare funds to invest are small relative to the amount needed to fund the borrower's project. The investor can liquidate the collateral if the borrower pays too little, preventing the borrower from absconding with it, or the investor can impose a nonmonetary penalty on the borrower.[2] Bankruptcy in the world today is some combination of these two actions. [Extracted from the article]