An Optimal Financial Contract When Posterior Participation Constraint Is Altered

This paper addresses the pricing of financial services particularly when the profiles of users are distorted due to the change of their reservation utility. The more valuable are the financial services, the higher price the investors are willing pay for them. However, the investors face incentive to mimic the lower type in order to save the cost. Facing this adverse selection problem, the financial intermediary is able to offer the separating price to the different types of agents in lieu of Spence-Mirrlees sorting condition. When the economy is relatively stable and steady, the financial intermediary is able to offer the investors different menu of contracts, with which they reveal their true types and pay the price for the financial service. This may not be the case when the agents are not symmetrically affected by the economy wide crisis. As the recess of economy continues since the onset of the financial crisis, the investor characteristic profiles change so that the investors' willingness to pay is modified. One way to overcome this problem is to maintain the separating price whereas not offering the service through credit rationing, as long as those investors are clearly identified. The current paper, however, shows that the pooling price is even beneficial to the financial intermediary rather than not offering the services because they can save the informational rents that will be paid out to the higher type investors otherwise.