Essays in financial contract theory

This thesis contains three theory essays on the role of contracting in financial markets. The first essay, called Procyclical Promises, shows that in the presence of two contracting frictions—capital diversion and renegotiation—increasing the cyclicality of an entrepreneur’s output can increase his debt capacity with potentially important implications for the macroeconomy and government policy. The second essay, called The Downside of Public Information in Contracting, studies a principal-agent problem with a verifiable public signal. It demonstrates that when agents are competitive, decreasing the precision of the public signal can be Pareto improving in a wide class of environments. We apply the framework to a problem of delegated portfolio management and argue that our results suggest that regulators should insist that credit ratings agencies coarsen their ratings categories. The third essay, called Credit Market Competition and Corporate Investment, uses a general equilibrium framework to study the effect of the price and supply of credit on firms’ project choices. It shows that for only intermediate levels of credit market competition do firms choose efficient projects.