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on Contract Theory and Applications |
| By: | Acharya, Viral V; Viswanathan, S |
| Abstract: | We consider a moral hazard setup wherein leveraged firms have incentives to take on excessive risks and are thus rationed when they attempt to borrow in order to meet liquidity shocks. The rationed firms can optimally pledge cash as collateral to borrow more, but in the process must liquidate some of their assets. Liquidated assets are purchased by non-rationed firms but their borrowing capacity is also limited by the moral hazard. The market-clearing price exhibits cash-in-the-market pricing and depends on the entire distribution of liquidity shocks in the economy. As moral hazard intensity varies, equilibrium price and level of collateral requirements are negatively related. However, compared to models where collateral requirements are exogenously specified, the endogenously designed collateral in our model has a stabilizing role on prices: For any given intensity of moral hazard problem, asset sales are smaller in quantity, and, in turn, equilibrium price is higher, when collateral requirements are optimally designed. This price-stabilizing role implies that the ex-ante debt capacity of firms is higher with collateral and thereby ex-post liability shocks are smaller. This stabilizes prices further, resulting in an important feedback: Collateral reduces the proportion of ex-ante rationed firms and thus leads to greater market participation. Our model provides an agency-theoretic explanation for some features of financial crises such as the linkage between market and funding liquidity and deep discounts observed in prices during crises that follow good times. |
| Keywords: | credit rationing; financial crises; fire sales; funding liquidity; market liquidity; risk-shifting |
| JEL: | D45 D52 D53 G12 G20 |
| Date: | 2008–01 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:6630&r=cta |
| By: | Dubois, Pierre; Jullien, Bruno; Magnac, Thierry |
| Abstract: | We develop and estimate a model of dynamic interactions in which commitment is limited and contracts are incomplete to explain the patterns of income and consumption growth in village economies of less developed countries. Households can insure each other through both formal contracts and informal agreements, that is, self-enforcing agreements specifying voluntary transfers. This theoretical setting nests the case of complete markets and the case where only informal agreements are available. We derive a system of non-linear equations for income and consumption growth. A key prediction of our model is that both variables are affected by lagged consumption as a consequence of the interplay of formal and informal contracting possibilities. In a semi-parametric setting, we prove identification, derive testable restrictions and estimate the model with the use of data from Pakistan villages. Empirical results are consistent with the economic arguments. Incentive constraints due to self-enforcement bind with positive probability and formal contracts are used to reduce this probability. |
| Keywords: | Contracts; Incomplete Markets; Informal Transfers; Risk sharing |
| JEL: | C14 D13 D91 L14 O12 |
| Date: | 2008–01 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:6661&r=cta |
| By: | Martinez-Miera, David; Repullo, Rafael |
| Abstract: | A large theoretical literature shows that competition reduces banks' franchise values and induces them to take more risk. Recent research contradicts this result: When banks charge lower rates, their borrowers have an incentive to choose safer investments, so they will in turn be safer. However, this argument does not take into account the fact that lower rates also reduce the banks' revenues from non-defaulting loans. This paper shows that when this effect is taken into account, a U-shaped relationship between competition and the risk of bank failure generally obtains. |
| Keywords: | Bank competition; Bank failure; Credit risk; Default correlation; Franchise values; Loan defaults; Loan rates; Moral hazard; Net interest income; Risk-shifting |
| JEL: | D43 E43 G21 |
| Date: | 2008–01 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:6669&r=cta |
| By: | Ohlendorf, Susanne; Schmitz, Patrick W. |
| Abstract: | We consider a repeated moral hazard problem, where both the principal and the wealth-constrained agent are risk-neutral. In each of two periods, the principal can make an investment and the agent can exert unobservable effort, leading to success or failure. Incentives in the second period act as carrot and stick for the first period, so that effort is higher after a success than after a failure. If renegotiation cannot be prevented, the principal may prefer a project with lower returns; i.e., a project may be "too good" to be financed or, similarly, an agent can be "overqualified." |
| Keywords: | Dynamic moral hazard; hidden actions; limited liability |
| JEL: | C73 D86 |
| Date: | 2008–02 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:6725&r=cta |
| By: | Poulsen, Thomas (Department of Business Studies, Aarhus School of Business) |
| Abstract: | This paper studies how large shareholders with bene…ts of control a¤ect …rms’ equity issue behavior and investment decisions. I introduce an explicit agency cost structure based on the large shareholder’s bene…ts of control. In a simple extension of Myers and Majluf [1984], I show that underinvestment is aggravated when there are bene…ts of being in control, and these bene…ts are diluted if equity is issued to …nance the investment project. I assume that large shareholders are constrained from further investments in their …rms, and that they maximize their own wealth, which includes the value of security bene…ts paid to all shareholders in proportion of ownership stake plus the value of private bene…ts from voting rights. Potential loss of control is calculated as the di¤erence in the largest shareholder’s voting power before and after a hypothetical equity issue. I use voting power as a representation of the large shareholders’expected private bene…ts. Using a large panel of U.S. data, I …nd that large shareholders’ concern with dilution of ownership and control cause …rms to issue less equity and to invest less. I also …nd that it has no signi…cant e¤ect whether new shares are issued to old shareholders or new shareholders. |
| Keywords: | Underinvestment; equity issue; ownership structure; influence; voting power; private benefits of control; potential loss of control; |
| Date: | 2008–03–19 |
| URL: | http://d.repec.org/n?u=RePEc:hhb:aarbfi:2008-02&r=cta |