Moral Hazard Problem Research Articles

Economic uncertainty, risk-taking incentives and production management

PurposeThis study aims to validate the link between production manipulation and a firm’s performance variability (fundamentals and stock returns). It explores whether executives' risk-taking incentives encourage production deviations around the normal level during uncertainty.Design/methodology/approachUtilizing panel data of manufacturing firms from Compustat over three decades, the study investigates production management practices during economic uncertainty. The Economic Policy Uncertainty Index (EPU) is employed as a key metric. The empirical strategy involves documenting the effect of economic uncertainty on overproduction and underproduction, examining the role of executive compensation and assessing the impact on risk.FindingsThe research finds that risk-taking incentives increase over/underproduction, particularly amplifying the extent of underproduction during uncertainty. Production deviation rises, indicating that firms take greater risk by engaging in abnormal business operations. The study’s results are robust against various econometric methods, emphasizing the influence of risk-taking incentives on corporate production decisions.Research limitations/implicationsWhile providing valuable insights, the study acknowledges inherent limitations, including factors influencing production decisions beyond risk-taking incentives. Further research could explore additional determinants for a comprehensive understanding.Practical implicationsThe findings highlight the potential dark side of executive compensation that motivates suboptimal risk-taking decisions, impacting risk, cost of capital and firm performance. Policymakers and compensation committees can use these insights to design efficient systems that mitigate moral hazard problems associated with productivity changes.Social implicationsThe study emphasizes the broader social implications of production manipulation under uncertainty. It prompts discussions on the ethical considerations of managerial opportunism, its potential consequences for stakeholders and market dynamics.Originality/valueThis study contributes to the literature by examining the role of economic uncertainty on production manipulation and the influence of risk-taking incentives. It extends the earnings management literature by considering real activity manipulation and emphasizing the importance of decomposing production deviation into positive and negative values.

Natural disasters and local government finance: Evidence from Typhoon Haiyan

This paper examines how natural disasters affect local public finances and their interplay with intergovernmental transfers and external resources. Exploiting the randomized nature of the 2013 Typhoon Haiyan, one of the most devastating natural disasters in recent history, we document its causal effect on the local government fiscal dynamics. Combining data on local government finance with reports on the level of damages and using difference-in-differences with instrumental variable to analyze the data, we show that local public revenue and expenditures remain largely unaffected, except for debt payments. However, we find important heterogeneity in local revenue responses: poorer municipalities raised comparatively lower revenue in the aftermath of the Typhoon. We also provide evidence that external funding did not lead to lower tax collection efforts, but instead leads to higher local expenditures, suggesting that disaster aid does not cause a moral hazard problem in local governments' spending decisions.

The Relation between CEO-Friendly Boards and the Value of Cash Holdings

Our study investigates how CEO-friendly boards influence the value and utilization of cash resources. In this paper, we analyze two conflicting views on CEO-friendly boards and their impact on corporate cash holdings: one view posits that such boards might be too lenient, fostering managerial moral hazard problem, while the other contends that they encourage CEOs to share information, despite CEOs knowing that better-informed boards could enforce stricter oversight. By measuring board friendliness through CEO-board social ties, we find that firms with a friendly board tend to maintain lower cash reserves but their excess cash is valued higher by the market compared to firms without such a board. Moreover, these boards deploy excess cash in ways that significantly enhance firm value. The results remain robust even after controlling for various governance variables and CEO characteristics. Our findings offer crucial insights for corporate practitioners and policymakers, highlighting the importance of appointing and retaining CEO-friendly directors to foster effective information exchange, especially in firms with substantial CEO-board information asymmetry in capital budgeting.

Faculty versus students: different perceptions of misconducts at university.

Academic integrity is a goal to be achieved by university institutions, and student academic behavioral misconduct is a phenomenon to be fought and eradicated. Two of the main problems faced by universities in this area are: (1) the lack of consensus among students and faculty on the seriousness of acts considered academic misconduct; and (2) the difficulty of noticing and controlling certain student behaviors. The main aim of this paper is to assess the importance of these two problems. For this purpose, the authors compare, on the one hand, students' and teachers' perceptions of the seriousness of different types of dishonest and inappropriate behaviors and, on the other hand, the frequency with which they report that these misconducts occur. Two samples were taken from the responses of students and teachers of the Economics and Business School of the University of Zaragoza. The first consisted of 333 students and the second of 72 teachers. The academic misconducts asked about were grouped into three categories: academic works, exams, and interpersonal relationships in the classroom. Nonparametric tests were used to study the significance of the differences observed in the responses of students and teachers. Results show that the greatest differences in the assessment of the seriousness of academic misconducts are in the group referring to interpersonal relationships. In terms of frequency, the study reveals that there is a serious problem of moral hazard in some of the behaviors analyzed, since the frequency with which teachers notice these practices is lower than that expressed by students. Based on these results, possible measures to be adopted in universities in order to eradicate the academic misconduct problem are discussed.

Information, Incentives, and CEO Replacement

ABSTRACT There are instances where CEO turnover occurs, even if the company has not made any significant strategy changes, and the new CEO possesses similar abilities as the predecessor. This paper aims to provide a rational explanation for this seemingly irrational phenomenon. One possible reason for this “aggressive” CEO turnover is the board’s desire to reduce the information rents earned by the privately informed CEO. Specifically, the incumbent CEO has a temptation to “sandbag” the board about profitability prospects to secure more generous incentive pay for future implementation, and a (seemingly aggressive) replacement policy helps discourage this kind of gaming. That is, instead of “information-based entrenchment” as suggested by the literature (Laux 2008; Inderst and Mueller 2010), this paper shows a countervailing effect that the CEO’s private information (combined with the later-stage moral hazard problem) may lead to her dismissal more often than the ex post efficient benchmark. JEL Classifications: D86; G34; M41.

Endogenous bank regulation and supervision: Long term implications

The role of bank regulation and supervision (RS) on financial stability and welfare has been subject to ongoing research, especially since the Great Recession. RS is expected to help eliminate the adverse selection and moral hazard problems that are abundant in financial transactions. In this paper, we present a general equilibrium model that is augmented by either a bank regulatory and supervisory agent who chooses the level of RS by maximizing bank profits, or by a macroprudential agent who minimizes non-performing loans (NPL). We compare the long-term outcomes of these scenarios and show that minimizing NPL is feasible for a larger and economically more viable range of parameter values than the alternatives. Moreover, for a comparable set of parameter combinations, the optimal choice of RS that minimizes NPL leads to both higher levels of steady state income and lower interest spreads as compared to RS that maximizes bank profits.

Risk management and optimal investment with inalienable human capital

We consider a moral hazard problem in a continuous-time model, where project risk is controllable. The unobservability of agent behavior creates information asymmetry, consequently influencing investor decisions. We utilize martingale methods to determine the optimal policy. The investor’s scaled value function is represented using an ordinary differential equation. We find that the manager’s search for new investors impacts the boundary conditions due to inalienable human capital. Using comparative static analysis, we find that the endogenous no-saving condition helps eliminate information asymmetry caused by unobserved effort. Moreover, as the agent’s continuation value increases, the company’s risk management target approaches the optimal risk management target under full information. A higher manager’s continuation value leads to inferior investment opportunities.

Flexible Moral Hazard Problems

This paper considers a moral hazard problem where the agent can choose any output distribution with a support in a given compact set. The agent's effort‐cost is smooth and increasing in first‐order stochastic dominance. To analyze this model, we develop a generalized notion of the first‐order approach applicable to optimization problems over measures. We demonstrate each output distribution can be implemented and identify those contracts that implement that distribution. These contracts are characterized by a simple first‐order condition for each output that equates the agent's marginal cost of changing the implemented distribution around that output with its marginal benefit. Furthermore, the agent's wage is shown to be increasing in output. Finally, we consider the problem of a profit‐maximizing principal and provide a first‐order characterization of principal‐optimal distributions.

Rules or capacity for the EU’s fiscal future? From Werner and McDougall to the present

PurposeThe COVID19 crisis has thrown wide open the debate on Europe’s Economic and Monetary Union’s (EMU) future. Next Generation EU (NGEU) has broken the stalemate over a central fiscal capacity. The open question is whether NGEU is a one-off or a first step. The suspension of the Stability and Growth Pact has given new urgency to the debate on reforming EMU’s fiscal rules.Design/methodology/approachThere is no debate as yet about how these two prospects relate to each other. This paper argues that a permanent fiscal capacity and revised rules should be seen as alternatives.FindingsThis study makes two claims: first, a fiscal capacity renders a reformed pact unnecessary and second, that is an optimal solution politically. A fiscal capacity would provide an efficient asymmetric shock absorber and therefore reduce the need for pre-emptive action against negative cross-border externalities. It would also provide an abundant supply of an EU-wide safe asset around which to structure the EU’s financial system, thus rendering unnecessary the backstopping of member states' debts.Originality/valueThis would restore democratic accountability while eliminating moral hazard and enforcement problems.

An incentive compatible ZD strategy-based data sharing model for federated learning: A perspective of iterated prisoner's dilemma

Federated learning has been increasingly adopted as an effective means to cope with the significant increase in the volume of training data needed for machine learning and address the privacy concerns in using these data. However, moral hazard may occur when individual data providers (IDPs) use smaller amounts or low-quality data to train their local models and submit these low-quality results (gradients) to free-ride on the benefits of the federated learning. Therefore, federated learning operators often face the dilemma of encouraging more IDPs to participate in data sharing and ensuring truthful contributions from IDPs to obtain high-quality global training results. This article proposes a spontaneous cooperative data-sharing model to address this dilemma. Through an iterated prisoner's dilemma model solved by the zero-determinant (ZD) strategy, we show that the optimal ZD strategies of all IDPs are to maximize their training efforts when participating in federated learning. According to the comparisons with other approaches through simulations, we demonstrate that either the two-IDP with binary strategies case or the multi-IDP with continuous strategies case could result in the optimal individual utility and social welfare. Therefore, the proposed spontaneous cooperative model effectively avoids the existing moral hazard problem in federated learning and provides a viable instrument for the federated learning operator to maximize the performance of the global model without the need to evaluate the quality of local gradients.

Forbearance versus Foreclosure in a General Equilibrium Model

AbstractIn a business cycle model with endogenous firms' dynamics and debt renegotiation, we show that during financial crises loan forbearance does not harm the economy unless banks imperfectly monitor loans, and loan opacity worsens banks' moral hazard problem. Aggressive interest rate reductions and quantitative easing limit defaults and financial crisis‐induced output contractions without hampering the entry of new firm entries. The decline in the natural interest rate, due to slower productivity growth and persistent liquidity shocks, potentially explains the observed long‐term trend in nonperforming loan shares.

Time‐inconsistent contract theory

AbstractThis paper investigates the moral hazard problem in finite horizon with both continuous and lump‐sum payments, involving a time‐inconsistent sophisticated agent and a standard utility maximizer principal: Building upon the so‐called dynamic programming approach in Cvitanić et al. (2018) and the recently available results in Hernández and Possamaï (2023), we present a methodology that covers the previous contracting problem. Our main contribution consists of a characterization of the moral hazard problem faced by the principal. In particular, it shows that under relatively mild technical conditions on the data of the problem, the supremum of the principal's expected utility over a smaller restricted family of contracts is equal to the supremum over all feasible contracts. Nevertheless, this characterization yields, as far as we know, a novel class of control problems that involve the control of a forward Volterra equation via Volterra‐type controls, and infinite‐dimensional stochastic target constraints. Despite the inherent challenges associated with such a problem, we study the solution under three different specifications of utility functions for both the agent and the principal, and draw qualitative implications from the form of the optimal contract. The general case remains the subject of future research. We illustrate some of our results in the context of a project selection contracting problem between an investor and a time‐inconsistent manager.

To play or not to play the ‘moral hazard card’: Germany and the European Union’s response to the Covid-19 crisis

ABSTRACT Avoiding moral hazard is a recurrent argument of those seeking to limit the development of European financial support mechanisms. Germany has been the traditional leader of this coalition of actors in the European Union (EU). However, in reaction to the Covid-19 pandemic, Germany supported an EU response which included grants and massive debt issuance. What was previously presented as unacceptable – because of moral hazard – became appropriate. This contribution seeks to explain why the German government ceased to emphasise the moral hazard problem in EU economic governance. We argue that the answer is not because of a challenge to the relevance of moral hazard per se, or because the Germans lost interest in the moral hazard problem, but rather because German policymakers were discursively constrained by one of the dominant meanings of moral hazard they had previously imposed – which lost its relevance in the context of a symmetric exogenous shock.

Analisis Perilaku Moral Hazard dan Adverse Selection pada Agency Problem di Pembiayaan Musyarakah PT. Bank Sumut KCPSY Binjai

This study aims to determine the form of behavior and how to handle agency problems caused by moral hazard behavior and adverse selection in musyarakah financing at PT. Bank Sumut KCPSY Binjai. The agency problem is the agency problem in the musyarakah product scheme. This type of research is field research with qualitative methods. Sources of data in this study include two categories, namely primary data and secondary data. The subjects in this study were employees of PT. Bank Sumut KCPSY Binjai in the management section that is competent in the field of musyarakah financing. The research results show that the form of moral hazard and adverse selection behavior at PT. Bank Sumut KCPSY Binjai namely the difficulty of banks assessing the true character of customers, errors in analysis, ethical deviations and lack of supervision (monitoring) carried out by banks. PT. Bank Sumut KCPSY Binjai Office made various efforts from screening, verification to monitoring. Furthermore, if the problem of moral hazard and adverse selection has occurred, the bank will handle it in two ways, namely saving financing in the form of first rescheduling, reconditioning, restructuring and solving problem financing by means of billing. lawsuits, execution of mortgage auctions, and WO

Task assignment and pay dispersion under moral hazard

We study a moral hazard problem where a principal assigns tasks that differ in the precision of their performance measures to agents who differ in their risk aversion. We solve for the optimal task assignment and observe that if both tasks are sufficiently easy to measure, the principal assigns the task involving the noisier performance measure to the less risk-averse agent. This assignment results in similar effort levels on both tasks and implies low pay dispersion within a firm. However, for generally noisy performance measures or if there is a significant range in the precision of the tasks’ performance measures, the principal assigns the task involving the noisier performance measure to the more risk-averse agent. This assignment drives effort levels apart and results in high pay dispersion among agents. The result of varying optimal pay dispersion is preserved in settings with interdependencies among tasks such as production synergies or correlated performance measures. We further show that the optimal task assignment always assures efficient risk bearing among agents, which stipulates that the agent who is least averse to facing risks bears a greater compensation risk.

Robust incentives for risk

This paper studies a moral hazard problem wherein the principal is uncertain about the agent’s risk preferences and production technology. The principal, desiring robustness, evaluates contracts according to their worst case payoff against the set of preferences and technologies that satisfy her assumptions about the agent and his capabilities. We show that contracts which exhibit robustness to severe risk taking behavior (i) pay their smallest transfer for all outputs below some lower threshold and (ii) pay their largest transfer for all outputs above some upper threshold. In our main result, we identify a class of environments in which two-wage binary bonus contracts are robustly optimal.

Moral hazard with excess returns

AbstractWe consider a public firm characterized by a moral hazard problem. A distinguished player is a CEO or activist shareholder who (i) is unrestricted to trade shares and (ii) has discretion to increase the value of this firm by exerting costly effort. von Lilienfeld-Toal and Rünzi (J Finance 69(3):1013–1050, 2014) investigate and confirm the empirical relevance of both these properties. This article shows that a distinguished player cannot be “priced in” correctly. In particular, such a firm is traded at a discount below its equilibrium value in a market equilibrium. Buyers can systematically earn excess returns on their investment. This prediction is indeed consistent with substantial positive abnormal returns for distinguished player firms within the S &P500 and S &P1500 sample reported in von Lilienfeld-Toal and Rünzi (J Finance 69(3):1013–1050, 2014).

Optimal incentives for managerial innovation

An agency model is proposed that identifies the optimal executive compensation scheme for a business where the owner’s delegation of investment decision-making to the manager gives rise to a two-dimensional moral hazard problem relating to the levels of managerial effort and innovation, respectively. The optimal executive compensation structure is shown to depend on which of the two moral hazard dimensions predominates, thus accounting for the coexistence in the real-world of bonus-like plans with different convexity degrees and risk-reward schemes. The model also identifies the conditions under which the efficient investment policy involves high innovation, highlighting the role played by the delegation of investment decisions in the coexistence of high-tech and more traditional industries.

Determinant of Sukuk Issuance in Indonesia From Information Asymmetry Perspective (2013-2022)

Previous research found that sukuk is more exposed to information asymmetry problems, especially adverse selection, than bond. Indonesia as the third largest country for sukuk market falls below its peers in terms of governance. It means the information asymmetry in Indonesia is relatively higher which could reduce market effectiveness. So to improve sukuk market in Indonesia, studying the implication of information asymmetry and how it affects the capital structure decision is important. This study try to explain the issuance of sukuk in Indonesia 2013-2022 from information asymmetry perspective. This study uses secondary data from 2013-2022 and would be done by using logistic regression to conclude if the variables representing adverse selection and moral hazard affect the decision of sukuk issuance. Our regression found evidence of adverse selection in Indonesia sukuk market but did not find moral hazard problem. The result supports previous research that concludes that sukuk structuration leads firms with higher financial distress and a lower reputation to enter the market.  The result could help investor to understand sukuk market and review their risk management procedure. It could also become additional material for government to design a suitable regulatory environment for a more govern sukuk market that would improve the development of sukuk market.

INTERMEDIATION AND SUSTAINABLE FINANCIAL SYSTEM STABILITY AMIDST THE COVID-19 PANDEMIC

This review aims to analyze the function of internalization and stabilization of the monetary-finance sector for the sustainability of financial system stability during the Covid-19 pandemic in Indonesia. The Covid-19 pandemic caused a deep recession in the national economy and a significant drop in the capital market index. Policy uncertainty over handling the pandemic and the continued emergence of various variants of Covid-19 exacerbated economic conditions. Bank Indonesia (BI) made several monetary policies to complement the policies taken by the government to maintain sustainability during the Covid-19 pandemic. Strengthening financial stability and supporting the intermediation recovery policy strengthens the monetary sector's sustainability and stabilization so that banks do not experience excessive pressure during Covid-19 and remain profitable. These perspectives were tested in the context of the Covid-19 pandemic, and the Indonesian banking and financial stability industry has shown sustainability in the last two years. On the other hand, the competition stability in the Covid-19 pandemic approach assumes that the borrower side of the relationship must be considered. Banks can charge exorbitant interest rates in collusive markets, increasing the cost of borrowing for businesses and triggering the moral hazard problem. Specifically for ASEAN and Indonesia, as a result of the recent global financial crisis in 2020, BI implemented expansionary monetary and fiscal policies in response to the crisis to stabilize its economies.