Informed Lending and Security Design




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    • Inderst is from the London School of Economics and CEPR; Mueller is from the NYU Stern School of Business and CEPR. We are especially grateful to an anonymous referee whose helpful comments substantially improved the paper. We also thank Rick Green (the editor), Andres Almazan, Jacqes Cremer, Darrel Duffie, Anthony Lynch, Colin Mayer, Patrick Rey, Jean-Charles Rochet, Tony Saunders, Raghu Sundaram, Elu von Thadden (our WFA discussant), Jean Tirole, Jeff Wurgler, and seminar participants at NYU, Yale, Kellogg, Rochester, UNC Chapel Hill, INSEAD, Wisconsin-Madison, LBS, LSE, Toulouse, Amsterdam, Frankfurt, Humboldt, the WFA Meetings in Los Cabos, the Oxford Finance Summer Symposium, and the European Summer Symposium in Financial Markets in Gerzensee for helpful comments. An earlier version of this paper circulated under the title “Credit Risk Analysis and Security Design.”


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 “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. 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.