Dynamic Adverse Selection and Debt

In many long-term relationships, parties may be reluctant to reveal their private information in order to benefit from their informational advantage in the future. We point out that the strategic use of debt by an uninformed party induces another party to reveal private information. Our argument, which is consistent with casual observation, is based on the idea that (renegotiable) debt is a credible commitment to end the long-term relationship if information is not revealed. We show that the strategic advantage of debt increases with good durability and we briefly address the financing decision of a regulated firm. Non Technical Abstract There is by now a large litterature on the advantages of debt finance based on two sorts of informational asymmetries between external investors and internal managers/entrepreneurs. Essentially debt is viewed either as a useful tool to help solve moral hazard problems, or as a signalling device. Both types of analysis suffer from some shortcommings, the main one being that there is probably some other ways to solve these problems at a much cheaper cost: why not offering proper monetary incentive contracts to managers or signalling with other instruments than the financial structure? Our idea is that debt makes a big difference in situations exhibiting dynamic adverse selection problems. When the interactions with a privately informed party are repeated over time, this party realises that disclosing some information at the current stage not only affects current payoffs but also the future informational rents. Compared to a static case, the possibility to repeat a relationship makes information revelation even more problematic. The longer the horizon, the more difficult the problem. Compared to other types of arrangement, debt has two interesting characteristics: first it creates a scope for bankruptcy, second renegotiating it in a way which increases the payoffs of everybody is unlikely to be feasible. We use these features in a particular illustration to make our point. We study the financing decision of a monopolist selling a good to a buyer who has private information about his true valution for the good. In a long term relationship, i.e. when parties can make more than one offer to each other, different analyses have shown after Coase that the monopolist is in fact competing with herself over time: her capacity to decrease the price subsequent to a low level of sales creates an incentive for any type of buyer (including buyers willing to pay a high price) to turn down any current offer. Buyers prefer to wait for a future discount. Hence, even high valuation buyers may refuse to reveal that they are willing to pay a relatively high price for the good at the