Agency problems, Screening and Increasing Credit Lines

Agency problems, Screening and Increasing Credit Lines

August 14,2007Working Paper No. 3433

We propose a model in which an optimal dynamic financing contract for a cash-constrained entrepreneur is a credit line with a growing credit limit. This simple contract, which resembles those used in practice, presents a good benchmark to understand dynamic moral hazard and adverse selection. In our setting the adverse selection problem is that only the agent initially knows the quality of the project. The moral hazard problem is that the agent, who privately observes stochastic cash flows, can manipulate them using hidden savings. It is appealing that the credit line is an incomplete contract: it does not spell out the agent’s actions, but gives him full discretion to draw and deposit funds up until the credit limit. The agent has incentives to use discretion in a way that is optimal for the principal.