The loan contract with costly state verification and subjective beliefs

• The classical costly state verification model assumes common beliefs.
• The case of diverse beliefs and risk aversion is studied here.
• The contract now serves several purposes simultaneously.
• Under suitable smoothness assumptions the optimality problem is finite dimensional.
• Optimism of entrepreneurs renders the financial accelerator more potent.

We provide a characterization of the optimal loan contract with costly state verification for the bank when the entrepreneur is risk averse and holds a belief different from that of the bank.While the optimality problem is formally infinite dimensional, under realistic assumptions it becomes finite dimensional. We provide conditions and examples to show that when the borrower is more optimistic than the bank, there may be only one verification region.A simple example, based on Bernanke and Gertler (1989), shows that as the borrower becomes more optimistic the financial accelerator (Bernanke et al., 1999) becomes more potent.