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Adverse Selection and Moral Hazards Reduction in Corporate Financing: A Mechanism Design Model for PLS Contracts

Author

Listed:
  • Adil Elfakir

    (Sheffield Hallam University)

  • Mohamed Tkiouat

    (Professor of Mathematics, Industrial Economics and Game theory, Laboratory of Research and Studies in Applied Mathematics, IFE-Lab, EMI School of Engineering)

Abstract

In this paper, we apply game theory to corporate financing using profit and loss sharing (PLS) contracts. We employ mechanism design theory using two agents, a bank and a corporation which seeks financing through PLS mode. We seek to find the usefulness of mechanism design in helping the bank separating low type from high type corporations by designing two bundles of contract with each contract directed in a compatible way towards the appropriate type of corporation. We found theoretical as well as simulation evidence that our model helps in minimizing asymmetric information in the form of adverse selection by forcing the corporation to reveal its type. The model also helps in reducing asymmetric information in the form of moral hazards. This is achieved by having the selected high type corporation select a high type contract using a moral hazard premium as an incentive.

Suggested Citation

  • Adil Elfakir & Mohamed Tkiouat, 2019. "Adverse Selection and Moral Hazards Reduction in Corporate Financing: A Mechanism Design Model for PLS Contracts," Annals of Economics and Finance, Society for AEF, vol. 20(1), pages 163-179, May.
    • Handle: RePEc:cuf:journl:y:2019:v:20:i:1:elfakirtkiouat
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    References listed on IDEAS

    as
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    6. Adil EL Fakir & Mohamed Tkiouat, 2016. "Single or Menu Contracting: A Game Theory Application of the Hersanyi Model to Mudaraba Financing," International Journal of Economics and Financial Issues, Econjournals, vol. 6(1), pages 221-230.
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    Cited by:

    1. Mahjus Ekananda, 2022. "The Nonlinear Impact of Payment System Innovation on Financial System Stability in the ASEAN-4 Countries," Economics and Finance in Indonesia, Faculty of Economics and Business, University of Indonesia, vol. 68, pages 114-131, Desember.

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    More about this item

    Keywords

    Sharing ratio; Adverse selection; Assymetric information; Moral hazards; Moral hazard premium (MHP); PLS contracts;
    All these keywords.

    JEL classification:

    • C70 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - General
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design

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