Bank Monitoring Incentives Under Moral Hazard and Adverse Selection

Abstract

Listen

Translate article

In this paper, we extend the optimal securitization model of Pages [41] and Possamai and Pages [42] between an investor and a bank to a setting allowing both moral hazard and adverse selection. Following the recent approach to these problems of Cvitanic, Wan and Yang [12], we characterize explicitly and rigorously the so-called credible set of the continuation and temptation values of the bank, and obtain the value function of the investor as well as the optimal contracts through a recursive system of first-order variational inequalities with gradient constraints. We provide a detailed discussion of the properties of the optimal menu of contracts.