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Long-term Financial Contracts Can Mitigate the Adverse Selection Problem in Project Financing

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  • Webb, David C

Abstract

This paper shows that long-term contracts can be used in competitive financial markets to separate entrepreneurs of different abilities. In equilibrium, poor entrepreneurs are financed with a sequence of standard-debt contracts. Good entrepreneurs are financed with a modified contract in which the terms of the second part of the contract are contingent upon whether default is observed at the first date. Sorting is achieved through the contingent term in the contract. In equilibrium, good entrepreneurs will typically pay high interest rates to start with, followed by relatively lower rates later if they are successful. The solution in the paper is contrasted with the use of collateral. Copyright 1991 by Economics Department of the University of Pennsylvania and the Osaka University Institute of Social and Economic Research Association.

Suggested Citation

  • Webb, David C, 1991. "Long-term Financial Contracts Can Mitigate the Adverse Selection Problem in Project Financing," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 32(2), pages 305-320, May.
    • Handle: RePEc:ier:iecrev:v:32:y:1991:i:2:p:305-20
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    Cited by:

    1. Werner, Arndt, 2008. "Do Credit Constraints Matter more for College Dropout Entrepreneurs?," MPRA Paper 11867, University Library of Munich, Germany.
    2. Kim, Sang-Joon & Bae, John & Oh, Hannah, 2019. "Financing strategically: The moderation effect of marketing activities on the bifurcated relationship between debt level and firm valuation of small and medium enterprises," The North American Journal of Economics and Finance, Elsevier, vol. 48(C), pages 663-681.
    3. Ahlin, Christian & Waters, Brian, 2016. "Dynamic microlending under adverse selection: Can it rival group lending?," Journal of Development Economics, Elsevier, vol. 121(C), pages 237-257.
    4. repec:bla:scotjp:v:49:y:2002:i:2:p:162-95 is not listed on IDEAS
    5. Martínez, Constanza & Cizek, Pavel & León, C., 2018. "Ownership Networks Effects on Secured Borrowing," Other publications TiSEM acb00047-4136-4a18-b5a4-a, Tilburg University, School of Economics and Management.
    6. Mason, Robin, 1998. "An options-based model of equilibrium credit rationing," Journal of Corporate Finance, Elsevier, vol. 4(1), pages 71-85, March.
    7. Chien-An Wang & Chin-Oh Chang, 2008. "Is It a Heavy Log that Broke the Camel’s Back? Evidence of the Credit Channel in Taiwan’s Construction Industry," International Real Estate Review, Global Social Science Institute, vol. 11(1), pages 38-64.
    8. Marco Becht & Carlos D. Ramírez, 2003. "Does Bank Affiliation Mitigate Liquidity Constraints? Evidence from Germany's Universal Banks in the Pre‐World War I Period," Southern Economic Journal, John Wiley & Sons, vol. 70(2), pages 254-272, October.
    9. Liang Han & Stuart Fraser & David J. Storey, 2009. "The Role of Collateral in Entrepreneurial Finance," Journal of Business Finance & Accounting, Wiley Blackwell, vol. 36(3-4), pages 424-455.
    10. Van Tassel, Eric, 1999. "Group lending under asymmetric information," Journal of Development Economics, Elsevier, vol. 60(1), pages 3-25, October.
    11. Parker, Simon C., 2007. "Entrepreneurial learning and the existence of credit markets," Journal of Economic Behavior & Organization, Elsevier, vol. 62(1), pages 37-46, January.
    12. Spiros Bougheas & Indraneel Dasgupta & Oliver Morrissey, 2011. "Repayment versus Investment Conditions and Exclusivity in Lending Contracts," Journal of Institutional and Theoretical Economics (JITE), Mohr Siebeck, Tübingen, vol. 167(2), pages 247-265, June.
    13. Uschi Backes-Gellner & Arndt Werner, 2007. "Entrepreneurial Signaling via Education: A Success Factor in Innovative Start-Ups," Small Business Economics, Springer, vol. 29(1), pages 173-190, June.
    14. Massimiliano Celli, 2016. "External VS. Internal Audit in the Accounting of Complex Contractual Instruments: A Survey on EU Firms," International Journal of Business and Management, Canadian Center of Science and Education, vol. 11(5), pages 1-22, April.

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