Financial Contracting with Adverse Selection and Moral Hazard

Abstract

This paper studies the problem of a bank which has to choose a contract offer to an entrepreneur in order to finance a risky investment project. The project outcome depends on the quality of the proposed project and the level of effort that the entrepreneur expends. Both quality and effort are not observable to the bank. Applying the revelation principle, the optimal contract is found by studying mechanisms which induce truthful revelation of the entrepreneur’s information. The optimal contract trades off gains in expected outcome from inducing higher effort against the increasing costs of truthful revelation. It is shown that a combination of debt and equity contracts solves the contracting problem and maximizes the bank’s profit. The bank proposes a menu of different combinations of debt and external equity financing, from which the entrepreneur can choose one.KeywordsMoral HazardAdverse SelectionOptimal ContractParticipation ConstraintIncentive ConstraintThese keywords were added by machine and not by the authors. This process is experimental and the keywords may be updated as the learning algorithm improves.