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Firms, Markets, and Contracts pp 165–184Cite as

Financial Contracting with Adverse Selection and Moral Hazard

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Part of the book series: Contributions to Economics ((CE))

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.

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Author information

Authors and Affiliations

  1. University of Cologne, Albertus Magnus Platz, 50923, Köln, Germany

    Mark Wahrenburg

Authors
  1. Mark Wahrenburg
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Editor information

Editors and Affiliations

  1. Institut für Organisation, Universität München, Ludwigstraße 28, D-80539, München, Germany

    Arnold Picot

  2. Volkswirtschaftliches Institut, Universität München, Schackstraße 4, D-80539, München, Germany

    Ekkehart Schlicht

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© 1997 Physica-Verlag Heidelberg

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Cite this paper

Wahrenburg, M. (1997). Financial Contracting with Adverse Selection and Moral Hazard. In: Picot, A., Schlicht, E. (eds) Firms, Markets, and Contracts. Contributions to Economics. Physica-Verlag HD. https://doi.org/10.1007/978-3-642-46988-6_10

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  • DOI: https://doi.org/10.1007/978-3-642-46988-6_10

  • Publisher Name: Physica-Verlag HD

  • Print ISBN: 978-3-7908-0947-3

  • Online ISBN: 978-3-642-46988-6

  • eBook Packages: Springer Book Archive

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