Informed Lending and Security Design

Abstract

We examine the role of security design when lenders make inefficient accept-or-reject decisions after screening projects. Lenders may be either 'too conservative', in which case they reject positive-NPV projects. Or they may be 'too aggressive', in which case they accept negative-NPV projects. In the first case, the uniquely optimal security is debt. In the second case, it is levered equity. Debt maximizes lenders' payoffs from financing low-NPV projects, i.e., projects that have a high probability mass on low cashflows, thus minimizing their conservatism. Conversely, levered equity minimizes lenders' payoffs from financing low-NPV projects, thus minimizing their aggressiveness. In equilibrium, profitable projects that are relatively likely to break even are financed with debt, while less profitable projects are financed with equity. Highly profitable projects are financed by uninformed arm's-length lenders. Finally, loan terms are insensitive with respect to the screening outcome: borrowers are either accepted, in which case they all obtain the same loan terms, or rejected.

Keywords: Security design, debt, equity, screening

JEL Classification: G20, G31, G32