TABLE OF CONTENTS Overview by Franklin Allen
University of Pennsylvania
Financial intermediaries use contracts with their customers and sell securities in financial markets. The design of the contracts they use and the securities they issue is thus of fundamental importance. The first chapter in this section, Chapter 1, by Paolo Fulghieri and Eitan Goldman, considers the design of debt contracts. The second chapter, Chapter 2, by Xudong An, Yongheng Deng, and Anthony B. Sanders, is concerned with the design of securities. In particular, it focuses on structured financing and the determination of subordination levels.
Chapter 1, Fulghieri and Goldman s chapter, provides a nice synthesis of the literature on the design of debt contracts. The basic question in much of this literature is to determine situations where debt contracts are optimal. The authors start by considering a static one-period framework. They consider the papers that show that debt contracts are optimal if it is costly to check whether the borrower is able to make the contractual payment or not. They then go on to consider the multiperiod case and the situation where the checking can be random rather than deterministic. While the costly state verification literature focuses on the allocation of cash flows, there is also a significant literature on the allocation of control rights. Here, if the borrower cannot make the payment, the penalty is that it is no longer possible to use the assets.
