nep-cta New Economics Papers
on Contract Theory and Applications
Issue of 2009‒10‒31
seven papers chosen by
Simona Fabrizi
Massey University Department of Commerce

  1. Money Talks. By Marie Hoerova; Cyril Monnet; Ted Temzelides
  2. Flexible Contracts By Piero Gottardi; Jean Marc Tallon; Paolo Ghirardato
  3. Optimal Unemployment Insurance with Monitoring By Setty, Ofer
  4. Competition or collaboration? The reciprocity effect in loan syndication By Jian Cai
  5. High-Powered Incentives in Developing Country Health Insurance: Evidence from Colombia’s Régimen Subsidiado By Grant Miller; Diana M. Pinto; Marcos Vera-Hernández
  6. Banking: a mechanism design approach By Fabrizio Mattesini; Cyril Monnet; Randall Wright
  7. BANKS RISK RACE: A SIGNALING EXPLANATION By Damien Besancenot; Radu Vranceanu

  1. By: Marie Hoerova (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Cyril Monnet (Federal Reserve Bank of Philadelphia, Research Department, Ten Independence Mall, Philadelphia, PA 19106-1574, USA.); Ted Temzelides (Rice University, Department of Economics, P.O. Box 1892, Houston, TX 77251-1892, USA.)
    Abstract: We study credible information transmission by a benevolent Central Bank. We consider two possibilities: direct revelation through an announcement, versus indirect information transmission through monetary policy. These two ways of transmitting information have very different consequences. Since the objectives of the Central Bank and those of individual investors are not always aligned, private investors might rationally ignore announcements by the Central Bank. In contrast, information transmission through changes in the interest rate creates a distortion, thus, lending an amount of credibility. This induces the private investors to rationally take into account information revealed through monetary policy. JEL Classification: D80, E40, E52.
    Keywords: Information, Interest rates, Monetary policy.
    Date: 2009–09
  2. By: Piero Gottardi; Jean Marc Tallon; Paolo Ghirardato
    Abstract: This paper studies the costs and benefits of delegating decisions to superiorly informed agents relative to the use of rigid, non discretionary contracts. Delegation grants some flexibility in the choice of the action by the agent, but also requires the use of an appropriate incentive contract so as to realign his interests with those of the principal. The parties’ understanding of the possible circumstances in which actions will have to be chosen and their attitude towards risk and uncertainty play then an important role in determining the costs of delegation. The main focus of the paper lies indeed in the analysis of these costs and the consequences for whether or not delegation is optimal. We determine and characterize the properties of the optimal flexible contract both when the parties have sharp probabilistic beliefs over the possible events in which the agent will have to act and when they only have a set of such beliefs. We show that the higher the agent’s degree of risk aversion, the higher the agency costs for delegation and hence the less profitable is a flexible contract versus a rigid one. The agent’s imprecision aversion in the case of multiple priors introduces another, additional agency costs; it again implies that the higher the degree of imprecision aversion the less profitable flexible contracts versus rigid ones. Even though, with multiple priors, the contract may be designed in such a way that principal and agent end up using ’different beliefs’ and hence engage in speculative trade, this is never optimal, in contrast with the case where the parties have sharp heterogeneous beliefs.
    Keywords: Delegation, Flexibility, Agency Costs, Multiple Priors, Imprecision Aversion
    JEL: D86 D82 D81
    Date: 2009
  3. By: Setty, Ofer
    Abstract: Monitoring the job-search activities of unemployed workers is a common government intervention. Typically, a caseworker reviews the unemployed worker's employment contacts at some frequency, and applies sanctions if certain requirements are not met. I model monitoring in the optimal unemployment insurance framework of Hopenhayn and Nicolini (1997), where job-search effort is private information for the unemployed worker. In the model, monitoring provides costly information upon which the government conditions the unemployment benefits. In the optimal monitoring scheme, endogenous sanctions and rewards, together with random monitoring, create effective job-search incentives for the unemployed worker. I calibrate the model to the US economy and find that the addition of optimal monitoring to the optimal unemployment insurance scheme decreases the variance of consumption by about two thirds and eliminates roughly half of the government's cost. I also find that compared with the optimal monitoring scheme, US states monitor too much and impose the sanctions over too short a time span. For the US on average, shifting to the optimal monitoring policy would generate savings of about $500 per unemployment spell.
    Keywords: Recursive Contracts; Unemployment Insurance; Job Search Monitoring
    JEL: H21 J65 J64 D82
    Date: 2009–01–06
  4. By: Jian Cai
    Abstract: It is well recognized that loan syndication generates a moral hazard problem by diluting the lead arranger's incentive to monitor the borrower. This paper proposes and tests a novel view that reciprocal arrangements among lead arrangers serve as an effective mechanism to mitigate this agency problem. Lender arrangements in about seven out of ten syndicated loans are reciprocal in the sense that lead arrangers also participate in loans that are led by their participant lenders. I develop a model in which syndicate lenders share reciprocity through such arrangements in a repeated-game setting as monitoring effort enhances lead arrangers' ability to profit from participating in loans led by others. The model generates specific predictions that I then confront with the data. I find strong and consistent empirical evidence on the reciprocity effect. Controlling for lender, borrower, and loan characteristics, I show that: (i) lead arrangers retain on average 4.3% less of the loans with reciprocity than those without reciprocity, (ii) the average interest spread over LIBOR on drawn funds is 11 basis points lower on loans with reciprocity, and (iii) the default probability is 4.7% lower among loans with reciprocity. These results indicate a cooperative equilibrium in loan syndication and have important implications to lending institutions, borrowing firms, and regulators.
    Keywords: Loans
    Date: 2009
  5. By: Grant Miller; Diana M. Pinto; Marcos Vera-Hernández
    Abstract: Despite current emphasis on health insurance expansions in developing countries, inefficient consumer incentives for over-use of medical care are an important counterbalancing concern. However, three factors that are more acute in poor countries (credit constraints, principal-agent problems, and positive externalities) result in substantial under-use and misuse as well. This paper studies Colombia’s Régimen Subsidiado, the first major developing country effort to expand insurance in a way that purposefully addresses these inefficiencies. Using a regression discontinuity design, we find that Colombia’s insurance program has provided risk protection while substantially increasing the use of traditionally under-utilized preventive services (with measurable health gains) through high-powered supply-side incentives.
    JEL: I10 O10
    Date: 2009–10
  6. By: Fabrizio Mattesini; Cyril Monnet; Randall Wright
    Abstract: The authors study banking using the tools of mechanism design, without a priori assumptions about what banks are, who they are, or what they do. Given preferences, technologies, and certain frictions - including limited commitment and imperfect monitoring - they describe the set of incentive feasible allocations and interpret the outcomes in terms of institutions that resemble banks. The bankers in the authors' model endogenously accept deposits, and their liabilities help others in making payments. This activity is essential: if it were ruled out the set of feasible allocations would be inferior. The authors discuss how many and which agents play the role of bankers. For example, they show agents who are more connected to the market are better suited for this role since they have more to lose by reneging on obligations. The authors discuss some banking history and compare it with the predictions of their theory.
    Keywords: Banks and banking
    Date: 2009
  7. By: Damien Besancenot (CEPN - Centre d'économie de l'Université de Paris Nord - CNRS : UMR7115 - Université Paris-Nord - Paris XIII); Radu Vranceanu (Department of Economics - ESSEC)
    Abstract: Many observers argue that the abnormal accumulation of risk by banks has been one of the major causes of the 2007-2009 …nancial turmoil. But what could have pushed banks to engage in such a risk race? The answer brought by this paper builds on the classical signaling model by Spence. If banks' returns can be observed while risk cannot, less efficient banks can hide their type by taking more risks and paying the same returns as the efficient banks. The latter can signal themselves by taking even higher risks and delivering bigger returns. The game presents several equilibria that are all characterized by excessive risk taking as compared to the perfect information case.
    Keywords: Banking sector, Risk strategy, Risk/return tradeoff, Signaling, Imperfect information.
    Date: 2009–10–14

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