Competitive Screening in Financial Markets when Borrowers can Recontract

This paper examines how the possibility of recontracting affects the financing of projects when an entrepreneur is privately informed about the distribution of returns. We consider a game where an entrepreneur solicits initial financing for a project from competing uninformed financiers. Once the project is undertaken, but before its returns are realized, the entrepreneur can solicit additional financial contracts from competing financiers. It is assumed that these financiers can observe all previously signed contracts and that the seniority of claims is respected in the case of bankruptcy; however, the entrepreneur is never committed not to sell junior claims to competing financiers. The main results of the paper are that (1) the equilibrium is characterized by separation but nevertheless the modalities of financing depend critically on the market's priors about the project's riskiness, in particular, the amount of collateral posted by the entrepreneur varies with the market's prior perceptions about the project, (2) when the market is optimistic about the project, there exists a unique equilibrium outcome, it is separating, but the standard incentivecompatibility constraints are not binding, (3) even if the market is very pessimistic about a project's chances of success, there always exists an equilibrium in which a good project receives sufficient financing, that is, the market does not collapse due to a Lemons effect, (4) the entrepreneur's inability to commit not to recontract may be considered Pareto improving in certain situations. We discuss how the results of the paper may help explain observed financial flows.