Incentive-Compatibility, Limited Liability and Costly Liquidation in Financial Contracting

Zhengqing Gui (), Ernst-Ludwig von Thadden and Xiaojian Zhao

CRC TR 224 Discussion Paper Series from University of Bonn and University of Mannheim, Germany

Abstract: We characterize an optimal financial contract when the firm’s realized cash flow is unobservable to the investor and the firm’s collateral can only be liquidated partially by resorting to the services of a costly third party. An optimal contract may exhibit a piecewise structure and vary with the liquidation cost and the firm’s actual liquidity shortage. Partial liquidation and wholesale transfers of collateral can coexist in an optimal contract. In contrast to part of the literature, the incentive-compatibility constraint incorporates the firm’s limited liability, and may be slack at the optimum. Allowing the firm to overcome an ex-post liquidity shortage by borrowing surreptitiously from a third party may reduce the firm’s ex-ante expected utility.

Keywords: Financial contracting; incentive-compatibility; limited liability; indivisible collateral; costly liquidation (search for similar items in EconPapers)
JEL-codes: D86 G33 (search for similar items in EconPapers)
Pages: 38
Date: 2018-12
New Economics Papers: this item is included in nep-cfn, nep-cta and nep-mic
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Journal Article: Incentive-compatibility, limited liability and costly liquidation in financial contracting (2019)
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Persistent link: https://EconPapers.repec.org/RePEc:bon:boncrc:crctr224_2018_064

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