Net Worth, Risk Taking and Investment

Abstract

This paper analyzes how agency problems in financial contracting determine risk-taking and investment. In perfect capital markets a risk-neutral firm would invest until the expected marginal return equals the interest rate. However, as firms with little net-worth face agency cost in financial contracting the shadow cost of external funding are increased. It is often argued that this wedge forces firms to underinvest (the 'balance-sheet-effect'). However, this claim is premature. Firms with low net worth, hence high cost of external financing, might even overinvest. We establish a robust though more subtle balance sheet effect. Agency problems in financial contracting generate risk avoidance at the firm level even when all actors are risk neutral. This may explain why during major economic downturns firms and banks shun risks that could be accepted in better times.