When entrepreneurs know the riskiness of the projects they want to finance better than potential investors, the transfer of funds between surplus and deficit units in the economy will in general be inefficient.
This paper explores the possibility of dealing with ex-ante asymmetric information in financial problems through the offer of an appropriate set of incentive compatible (i.c.) sharing contracts, i.e. contracts specifying how to share the proceeds of a risky project, such that, when the entrepreneur selects one out of the offered set, he thereby reveals his riskiness.
No collateral requirements are employed to achieve incentive compatibility, which is obtained by appropriately choosing the expected value and the concavity of the contracts in the optimal set. Characterization and welfare properties of the set of optimal i.c. sharing contracts are provided, showing the existence of a tradeoff between surplus extraction and risk-sharing.
The paper also provides a new insight on the relationship between ex-ante asymmetric information and credit rationing. Stiglitz and Weiss showed the former to be responsible for the latter. We show that equilibrium credit rationing will be avoided if optimal i.c. sharing contracts are used and an appropriate notion of competitive equilibrium is employed (Riley, 1979). Thus credit rationing appears rather as the consequence of a "legal restriction", whereby the contracts are constrained to be standard debt contracts.
