Moral Hazard Costs Research Articles

College Education and Income Contingent Loans in Equilibrium: Theory and Quantitative Evaluation

We investigate the welfare implications of income-contingent loans (ICLs) used for financing college education in presence of the dropout risk that depends on unobservable effort. Using a simple model, we show that the laissez-faire enrollment is inefficiently low due to missing insurance against dropping out. However, providing this insurance generates a moral hazard cost of lowering effort. We show that ICLs can implement the second best allocation. Then, we construct a heterogeneous agent OLG life-cycle model, calibrate it to the US and show that ICLs significantly increase welfare and that their non-linear structure is essential to delivering high welfare gains.

Welfare consequences of access to health insurance for rural households: Evidence from the New Cooperative Medical Scheme in China.

This study evaluates the welfare benefits of the New Cooperative Medical Scheme (NCMS), the main public health insurance plan for the rural population in China. The findings show that the value of the NCMS to recipients is slightly lower than the government's costs of implementation, ranging from 0.79 to 0.97 per RMB of the resource cost of the NCMS. The estimated moral hazard costs are low compared with the total benefits. It is also estimated that the benefits originating from the NCMS's insurance function only constitute 20% of the total benefits, suggesting a need for higher generosity levels among rural households. Our results shed new light on the welfare effects of access health insurance among low- and middle-income households.

Feasibility and Sustainability of Community Based Health Insurance in Rural Areas Case Study of Musana, Zimbabwe

The Zimbabwe Demographic Health Survey (ZDHS 2010-11) showed that only 6 percent of the population is covered by health insurance in Zimbabwe. This study investigated the feasibility, acceptability and sustainability of Community Based Health Insurance (CBHI) as an alternative to pooling risk and financing social protection in Zimbabwe. Willingness to Pay (WTP) for health insurance and socioeconomic data were collected through interviews with 121 household heads selected using a 2-stage sampling procedure on 14 villages in Musana and Domboshava rural areas, a population which is largely unemployed and reliant on subsistence agriculture. A CBHI scheme was established and followed up for 3 years documenting data on visits made, financial contributions from recruited households and their actual health expenditures. Findings indicate that CBHI is generally accepted as a means of health insurance in rural communities. The median willingness to pay for health insurance was $5.43 against monthly expenditures ranging of up to $180. The low WTP is attributable to low incomes as only 3.4 percent of the respondents relied on formal employment. Trust issues, adverse selection, moral hazard, and administration costs were challenges threatening sustainability of CBHI. A financial gap averaging 42% was generally on a downward trend and was closed by the end of the follow-up study as contributions were equivalent to medical expenses. We conclude that CBHI is feasible, has potential for sustainability and should be considered as a springboard for the planned Zimbabwean National Health Insurance.

Effects of the Sharing Economy on Sequential Innovation Products

The emergence of the sharing economy has affected consumers and traditional manufacturers. We focus on product sharing and analyze its impacts on the manufacturer that offers sequential innovation products. We develop a two‐period model in which a monopoly manufacturer sells an old product and introduces a new product in each period; in the same period, an owner who bought a product for self‐use from the manufacturer in the previous period may rent the product out because of the low self‐use value in this period. Our analysis reveals that the sharing market increases or decreases the manufacturer’s profit, and this is mainly determined by the moral hazard cost and the salvage value of sharing products. Furthermore, the sharing market has an insignificant effect on the upgrading of products, but there is a bumping‐down effect on old products’ sales. Finally, the effect of the sharing market on the revenue of the owner and the sharing platform mostly depends on the risk of moral hazard, and it also affects the manufacturer’s product rollover strategy.

Optimal unemployment insurance with monitoring

I model job‐search monitoring in the optimal unemployment insurance framework, in which job‐search effort is the worker's private information. In the model, monitoring provides costly information upon which the government conditions unemployment benefits. Using a simple one‐period model with two effort levels, I show analytically that the monitoring precision increases and the utility spread decreases if and only if the inverse of the worker's utility in consumption has a convex derivative. The quantitative analysis that follows extends the model by allowing a continuous effort and separations from employment. That analysis highlights two conflicting economic forces affecting the optimal precision of monitoring with respect to the generosity of the welfare system: higher promised utility is associated not only with a higher cost of moral hazard, but also with lower effort and lower value of employment. The result is an inverse U‐shaped precision profile with respect to promised utility.

An endogenous structural credit risk model incorporating with moral hazard and rollover risk

In this paper, we embed optimal contracting between the manager and equity holders into Leland-Toft endogenous structural credit risk model to study the impact of moral hazard on the firm's credit risk with rollover debts. Our model quantitatively shows that the agency costs induced by the moral hazard can endogenously have significant impacts on credit spreads, besides the costs of rolling over the maturing debts of the firm. It originates from the conflicts that these two costs should be covered by equity holders while both the manager and maturing debt holders are still paid in full. The numerical results show that the credit spread with the agency costs of moral hazard is larger than the one without the agency costs. Thus, the moral hazard could be used to explain “credit spread puzzle” as an endogenous factor. The explicit formulae of the equity value, the debt value, and the endogenous default boundary are also given.

Consumer Ruthlessness and Mortgage Default during the 2007 to 2009 Housing Bust

ABSTRACTFrom 2007 to 2009 U.S. house prices plunged and mortgage defaults surged. While ostensibly consistent with widespread “ruthless default,” analysis of detailed mortgage and house price data indicates that borrowers do not walk away until they are deeply underwater—far deeper than traditional models predict. The evidence suggests that lender recourse is not the major driver of this result. We argue that emotional and behavioral factors play an important role in decisions to continue paying. Borrower reluctance to walk away implies that the moral hazard cost of default as a form of social insurance may be lower than suspected.

Sovereign Debt and Moral Hazard: The Role of Collective Action and Contractual Ambiguity

The ambiguous phrasing of pari passu (equal treatment) clauses in sovereign debt contracts has long baffled commentators. We show that in the presence of asymmetric information on a sovereign borrower's ability to pay, an uncertain clause gives rise to a collective action problem among creditors that can reduce sovereign moral hazard. By varying the clause, parties can calibrate a sovereign's expected default costs and payments to creditors and thereby optimally trade off the sovereign's moral hazard and (deadweight) default costs. As information asymmetry decreases, a pari passu clause becomes a coarser instrument for configuring creditors' incentives and mitigating moral hazard.

Do tournaments solve the adverse selection problem?

This paper provides a solution to a puzzle in the analysis of tournaments, that of why there is no agent discrimination or differential contracting in certain business practice settings. The paper examines the problem of a principal contracting with multiple agents whose activities are subject to common shocks. The presence of common shocks invites the use of relative performance evaluation to minimize the costs of moral hazard. But, in the additional presence of adverse selection, the analysis shows that there may be no need for ex ante screening through menus of offers. This is so because the principal becomes better informed ex post about agent types, via the realization of common uncertainty, and can effectively penalize or reward the agents ex post. Thus, unlike the standard adverse selection problem without common uncertainty where the principal always benefits from ex ante screening, it is shown that ex post sorting through relative performance evaluation reduces the scope for ex ante screening through menus, and can eliminate it completely if agents are known to not be very heterogeneous. This is consistent with observed practice in industries where the primary compensation mechanism is a cardinal tournament which is uniform among employees. The analysis connotes that by using relative instead of absolute performance measures, firms with employees who are not substantially heterogeneous not only can alleviate the agency problem, but there is also no need to extract the agents' ex ante private information about their innate abilities via a screening menu.

A methodological proposal to evaluate the cost of duration moral hazard in workplace accident insurance.

The cost of duration moral hazard in workplace accident insurance has been amply explored by North-American scholars. Given the current context of financial constraints in public accounts, and particularly in the Social Security system, we feel that the issue merits inquiry in the case of Spain. The present research posits a methodological proposal using the econometric technique of stochastic frontiers, which allows us to break down the duration of work-related leave into what we term "economic days" and "medical days". Our calculations indicate that during the 9-year period spanning 2005-2013, the cost of sick leave amongst full-time salaried workers amounted to 6920 million Euros (in constant 2011 Euros). Of this total, and bearing in mind that "economic days" are those attributable to duration moral hazard, over 3000 million Euros might be linked to workplace absenteeism. It is on this figure where economic policy measures might prove more effective.

Optimal Unemployment Insurance with Endogenous Negative Duration Dependence

This article characterizes optimal unemployment insurance (UI) in an economy with endogenous negative duration dependence in hiring rates for the unemployed. The characterization generalizes the standard Baily–Chetty result and is independent of the particular mechanism generating endogenous hiring rates. I find that at the social optimum, UI equates the moral hazard cost with the sum of the insurance benefit and a new externality correction term. The sign of this externality correction term depends, in part, on the responsiveness of hiring rates to the UI benefit. I show how the effect of UI on hiring rates in turn depends on the particular assumptions about firm behavior, considering the cases of employer screening and human capital depreciation models.

Removing Moral Hazard and Agency Costs in Banks: Beyond CoCo Bonds

The convex payoffs for equityholders in a corporate structure results in agency costs and moral hazard problems. The implicit government guarantee for banks accentuates these. We believe that the Basel III related bail-in contingent convertible (CoCo) structures do only not solve these problems, but may even aggravate them. In this paper we suggest solutions. The first is to replace the currently issued writedown/off and equity-conversion CoCo structures with a market-price equity-conversion CoCo bonds. This mirrors the full dilution effect of an ordinary equity raise in a distressed situation to reduce incentives for high risk-taking by equityholders. The second is to establish a Contingent Equity Base that replaces the incumbent shareholders once the CoCo is triggered. This will finally remove the perverse risk-taking incentives. The valuation of the CEB is then suggested.

Should Unemployment Insurance Vary with the Unemployment Rate? Theory and Evidence

We study how the marginal welfare gain from increasing the unemployment insurance (UI) benefit level varies over the business cycle. We do this by estimating how the moral hazard cost and the consumption smoothing benefit of UI vary with labour market conditions, which we identify using variation in the interaction of UI benefit levels with the unemployment rate within U.S. states over time. We find that the moral hazard cost is procyclical, greater when the unemployment rate is relatively low. By contrast, we do not find evidence that the consumption smoothing benefit varies with the unemployment rate. We use these empirical results to estimate the marginal welfare gain, and we find that it is modest on average, but varies positively with the unemployment rate.

The Optimal Timing of Unemployment Benefits: Theory and Evidence from Sweden

This paper provides a simple, yet robust framework to evaluate the time profile of benefits paid during an unemployment spell. We derive sufficient-statistics formulae capturing the marginal insurance value and incentive costs of unemployment benefits paid at different times during a spell. Our approach allows us to revisit separate arguments for inclining or declining profiles put forward in the theoretical literature and to identify welfare-improving changes in the benefit profile that account for all relevant arguments jointly. For the empirical implementation, we use administrative data on unemployment, linked to data on consumption, income, and wealth in Sweden. First, we exploit duration-dependent kinks in the replacement rate and find that, if anything, the moral hazard cost of benefits is larger when paid earlier in the spell. Second, we find that the drop in consumption affecting the insurance value of benefits is large from the start of the spell, but further increases throughout the spell. In trading off insurance and incentives, our analysis suggests that the flat benefit profile in Sweden has been too generous overall. However, both from the insurance and the incentives side, we find no evidence to support the introduction of a declining tilt in the profile. (JEL D82, E21, E24, J64, J65)

Corruption in PPPs, incentives and contract incompleteness

We analyze risk allocation and contractual choices when public procurement is plagued with moral hazard, private information on exogenous shocks, and threat of corruption. Complete contracts entail state-contingent clauses that compensate the contractor for shocks unrelated to his own effort. By improving insurance, those contracts reduce the agency cost of moral hazard. When the contractor has private information on revenues shocks, verifying messages on shocks realizations is costly. Incomplete contracts do not specify state-contingent clauses, thereby saving on verifiability costs. This makes incomplete contracts attractive even though they entail greater agency costs. Because of private information on contracting costs, a public official may have discretion to choose whether to procure under a complete or an incomplete contract. When the public official is corrupt, such delegation results in incomplete contracts being chosen too often. Empirical predictions on the use of incomplete contracts and policy implications on the benefits of standardized contracts are discussed.

The Cost of Moral Hazard and Limited Liability in the Principal-Agent Problem

This article studies a principal-agent problem with discrete outcome and effort level spaces. The principal and the agent are risk neutral and the latter is subject to limited liability. We consider the ratio between the first-best social welfare and the social welfare arising from the principal's optimal pay-for-performance contract, i.e., the welfare loss ratio. In the presence of moral hazard, we provide simple parametric bounds on the welfare loss ratio of a given instance of the problem, and then study the worst-case welfare loss ratio among all problem instances with a fixed number of effort and outcome levels. Key parameters for these bounds are the number of possible effort levels and the likelihood ratio evaluated at the highest outcome. As extensions, we also look at linear contracts and at cases with multiple identical tasks. Our work constitutes an initial attempt to quantify the losses arising from moral hazard problems when the agent is subject to limited liability, and shows that these losses are non-negligible in the worst case (e.g., the welfare loss can approach 100% when the number of possible effort levels is large).

Moral hazard and sorting in a market for partnerships

We examine how equilibrium sorting patterns in a matching market for partnerships are impacted by the presence of bilateral moral hazard in a repeated production setting. We find that this impact depends on how the cost of moral hazard manifests itself—whether efficient effort is not feasible or desirable from the beginning, or whether inefficient effort is resorted to only as a punishment equilibrium. Which of these is the case depends on both the details of the technology and the contractual environment. In the former case, the presence of moral hazard moves the market away from positive sorting. In the latter case, whether moral hazard favors positive or negative sorting depends on how the power of incentives needed to implement effort varies with the observable types of the agents.

What makes banking crisis resolution difficult? Lessons from Japan and the Nordic Countries

Banking crisis resolution is often a long-lasting process with large fiscal and social costs. We ask which difficulties authorities face when choosing and implementing resolution packages. We survey the literature analyzing the impact of single resolution instruments on moral hazard and fiscal costs. We argue that no best-practice resolution package exists and that the implementation of a package is subject to coordination failures. Since crisis resolution packages are country-specific, we follow a case-study approach and describe how regulators in Japan and the Nordic countries during the 1990s solved their financial crises. We identify several obstacles the authorities in these countries were faced with and analyse their crisis resolution in the context of moral hazard and fiscal costs. Finally, we use these lessons to reassess the policy reactions in the US and in Europe during the recent financial crisis.

An Assessment of TARP Assistance to Financial Institutions

Six years after the passage of the 2008 Troubled Asset Relief Program, commonly known as TARP, it remains hard to measure the total social costs and benefits of the assistance to banks provided under TARP programs. TARP was not a single approach to assisting weak banks but rather a variety of changing solutions to a set of evolving problems. TARP's passage was associated with significant improvements in financial markets and the health of financial intermediaries, as well as an increase in the supply of lending by recipients. However, a full evaluation must also take into account other factors, including the risks borne by taxpayers in the course of the bailouts; moral-hazard costs that could result in more risk-taking in the future; and social costs related to perceived unfairness. Our evaluation is organized in five parts: 1) What did policymakers do? 2) What are the proper objectives of interventions like TARP assistance to financial institutions? 3) Did TARP succeed in those economic objectives? 4) Were TARP funds allocated purely on an economic basis, or did political favoritism play a role? 5) Would alternative policies, either alongside or instead of TARP, and alternative design features of TARP, have worked better?

Company-specific characteristics affecting oil and gas reserves disclosure in the United Kingdom

This paper investigates company-specific characteristics affecting oil and gas reserves disclosure in the United Kingdom. Using a sample selected through purposive and stratified random sampling from 83 UK oil and gas exploration and production companies listed on the London Stock Exchange (LSE) the paper helped to shed light on this critical disclosure issue. The results provide evidence that company's characteristics of firm size, size of auditor, debt capital and listing status significantly affect the extent of disclosure of oil and gas reserves information, while stage of firm operation was not found significant. Furthermore, the need to reduce the agency cost of information asymmetry and moral hazard, and thus reduce contracting and monitoring cost, as well to signal prospects to stakeholders as determined by the firm size, use of debt capital, size of auditor, and listing status, will compel companies to disclose oil and gas reserves even where such disclosure is discretionary as is the case in the UK. The findings are relevant to analysts and investors who use oil and gas reserve data disclosed by companies in valuing firms. Of interest to them would be information on reserves quantity data and narratives provided in the website in contradistinction to the valuation based on the annual report alone.