Adverse Selection and Moral Hazards Reduction in Corporate Financing: A Mechanism Design Model for PLS Contracts

In this paper, we apply game theory to corporate financing using profit and loss sharing (PLS) contracts. We employ mechanism design theory using two agents, a bank and a corporation which seeks financing through PLS mode. We seek to find the usefulness of mechanism design in helping the bank separating low type from high type corporations by designing two bundles of contract with each contract directed in a compatible way towards the appropriate type of corporation. We found theoretical as well as simulation evidence that our model helps in minimizing asymmetric information in the form of adverse selection by forcing the corporation to reveal its type. The model also helps in reducing asymmetric information in the form of moral hazards. This is achieved by having the selected high type corporation select a high type contract using a moral hazard premium as an incentive.