Bank monitoring incentives under moral hazard and adverse selection

Abstract

In this paper, we extend the optimal securitization model of Pagès and Possamaï and Pagès between an investor and a bank to a setting allowing both moral hazard and adverse selection. Following the recent approach to these problems of Cvitanić, Wan and Yang, 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.

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International