Creditor Commitment in a Sequential Investment Model

A simple contracting environment with a creditor who has wealth and a entrepreneur who has a two-period investment project is studied. After observing the partial completion of the project at the end of first period, the creditor may decide whether to refinance it or liquidate it. Contracting is subject to moral hazard and limited liability each period. The creditor prefers a contract that commits him not to refinance if and only if the extent of moral hazard problem is sufficiently high. Such a commitment may not be sequentially rational, however. The role of competition and hidden information in enforcing commitment is studied. When credit supply is scarce and the creditor lacks commitment, competition from other potential entrepreneurs may not be a credible deterrent against refinancing because of the wedge between the liquidation value of the output and its value as an input for second period. Sufficient conditions are developed under which hidden information makes commitment sequentially rational