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States engage in coercive diplomacy by sponsoring militant violence against their rivals. This gives militant groups’ sponsors bargaining power, but may produce moral hazard, because it can empower groups so much that sponsors cannot control them. This study develops a game theoretic model to explain why states take the risk of sponsoring militant groups. The model demonstrates that sponsorship may be a form of costly signalling that increases the probability both of bargaining failure and of a negotiated settlement favourable to the sponsor. The model further demonstrates that only moderately weak states and major powers are likely to gain coercive power through sponsorship. Data on militant violence during the period 1989–2001 support the model's predictions.