Monitoring, liquidation, and security design

By identifying the possibility of imposing a creditable threatof liquidation as the key role of informed (bank) finance ina moral hazard context, we characterize the circumstances underwhich a mixture of informed and uninformed (market) financeis optimal, and explain why bank debt is typically secured,senior, and tightly held. We also show that the effectivenessof mixed finance may be impaired by the possibility of collusionbetween the firms and their informed lenders, and that in theoptimal renegotiation-proof contract informed debt capacitywill be exhausted before appealing to supplementary uninformedfinance.