Moral Hazard Problem Research Articles

How private equity-backed buyout contracts shape corporate governance

ABSTRACT This paper explores how contracts in private equity-backed buyouts shape corporate governance in portfolio companies. Drawing upon agency theory and incomplete contracting theory, 50 actual contracts are analyzed in detail. Contracts focus on reducing adverse selection risks through limiting pre-investment information asymmetries and aligning the goals of investors and sellers. Moral hazard risks vis-à-vis management are limited through limiting post-investment information asymmetries and limiting shirking behavior through limiting free cash flows. Goal alignment is achieved through high-powered incentive structures combined with shifting risk of underperformance to management. Managerial hold-up problems are addressed through restricting share transactions and limiting managerial actions. Residual powers and contingencies are mainly used to deal with incomplete contract designs due to uncertainties. Few clauses are used to address the reverse agency problem in which management is protected against moral hazard problems created by the private equity investor. PE contracts have transparent and very strong outcome-based cash flow rights, both limiting downside risk and rewarding upside potential. This contrasts with VC contracts which are especially contingency-based given the high levels of uncertainty of the portfolio companies.

INCENTIVES, SOCIAL NORMS, AND BUSINESS CYCLE: AN EXAMPLE OF BUSINESS LOANS PROVISION BY ISLAMIC BANKS

The interaction of social norms and incentives is a subject of growing interest in economic literature. Basov and Bhatti (2013) pointed out that invoking a social norm is both a blessing, since it allows mitigating moral hazard problem, and a curse, since it restricts the class of admissible contractual arrangements. In this paper, we reiterate this point using particular example of the effects of restrictions imposed on contracts by Shariah law on the optimal risk-incentive trade-off. We show that extra rigidity imposed by Shariah law leads to a greater reluctance to invest into daring new ideas, which are profitable in expectation, but may also result in significant losses. A shared set of social norms between the lender and the entrepreneur allows mitigating adverse consequences of the excess rigidity through creation of good will and may even lead to an improved performance. The adverse consequences may vary according to the stages of business cycle. As a result, recessions can have negative long-term effects and longer booms may be followed by longer recessions. We also hypothesize that turning a social norm into a law will deprive it of the ability to generate good will, while leaving the negative aspects intact. We find a tentative support of this hypothesis by comparing relative performance of Islamic banks in three regions: South East Asia (primarily, Malaysia), Middle East, and the UK.

Surety bonds and moral hazard in banking

We examine a policy in which owners of banks provide funds in the form of a surety bond in addition to equity capital. This policy would require banks to provide the regulator with funds that could be invested in marketable securities. Investors in the bank receive the income from the surety bond as long as the bank is in business. The capital value could be used by bank regulators to pay off the banks’ liabilities in case of bank failure. After paying depositors, investors would receive the remaining funds, if any. Analytically, this instrument is a way of creating charter value but, as opposed to Keeley (1990) and Hellman, Murdock and Stiglitz (2000), restrictions on competition are not necessary to generate positive rents. We demonstrate that capital requirements alone cannot prevent the moral hazard problem arising from deposit insurance.

A Quantitative Model of Dynamic Moral Hazard

Abstract We develop an equilibrium model with moral hazard, which arises because some productivity shocks are privately observed by firm managers only. We characterize the optimal contract and its implications for firm size, growth, and managerial pay-performance sensitivity and exploit them to quantify the severity of the moral hazard problem. Our estimation suggests that unobservable shocks are relatively modest and account for about 10$\%$ of the total variation of firm output. Nonetheless, moral-hazard-induced incentive pay is quantitatively significant and accounts for 50$\%$ of managerial compensation. Eliminating moral hazard would result in about a 1$\%$ increase in aggregate output.

Trust and Trustworthiness in Procurement Contracts with Retainage

In complex procurement projects, it is difficult to write enforceable contracts that condition price upon quality. Supplier nonperformance becomes an acute risk, particularly when there is intense competition for the contract. An established incentive mechanism used to mitigate the problem of supplier nonperformance is retainage, in which the buyer sets aside a portion of the purchase price. After project completion, the buyer determines the amount of retainage that is released to the seller, considering any defects that arise. Although generally a feasible contract form to implement, the practical difficulties in assessing completion introduce a moral hazard for the buyer. We develop a structurally new game and experimental design to offer managerial insights on how retainage principles mediate trust and trustworthiness in competitive procurement settings with moral hazard. The experimental results suggest that if trust in the procurement relationship is strong enough, then retainage can mitigate the seller-side moral hazard problem and substitute for reputation in a fragmented supply chain at the cost of inflated tender prices. In high retainage structures, there is a tradeoff between trade efficiency and supplier participation in request for bids. We further develop a model of fair payment norms and offer managerial insights on how to design the retainage mechanism, conditional on prevailing levels of trust and beliefs about fairness. This paper was accepted by Vishal Gaur, operations management. Funding: This work was supported by the Economic and Social Research Council [Grant ES/R500963/1]. Supplemental Material: The data files and online appendix are available at https://doi.org/10.1287/mnsc.2022.4516 .

Reexamine the Role of the Financial Institution Management During Card Debt Crisis or the COVID-19

Due to the increasing popularity of financial technology and the lifting of financial regulations, various financial institutions have become increasingly competitive and actively expand their consumer finance business. Changes in generational consumption behavior have led to excessive credit expansion, excessive debt or bad credit records. All of these result in the emergence of adverse selection and moral hazard problems of information asymmetry, and finally cause the card debt crisis in 2005. This article focuses on variables such as the number of cards in circulation, retail sales volume, revolving balance, and overdue ratios of credit cards in public and private banks, and examine whether the information asymmetry in the credit card market has been improved ,with the financial institution management. Furthermore, due to the COVID-19 ,exploring whether the information asymmetry has been worsened or improved deserves the attention of the financial authority again. The results reveal that continuous financial institution management is very important and effective during the card debt period or the pandemic.

Accounting comparability and relative performance evaluation by capital markets

This paper examines how accounting comparability affects the monitoring role and the risk allocation role of capital markets. We develop the statistical and informational properties of accounting reports under varying degrees of comparability. A perfectly comparable accounting information system enables investors to perfectly infer the difference between any two firms' future cash flows although investors remain uncertain about either firm's cash flow. Comparability alleviates entrepreneurs' moral hazard problem by strengthening the price response to the relative accounting performance, but can induce excessive price risk as well as residual systematic cash flow risk. Unlike the investors (users) who earn their surplus by bearing the residual systematic risk, the entrepreneurs (preparers) do not find perfect comparability desirable. Hence, a standard setter would mandate higher comparability than preferred by preparers, but not perfect comparability.

Effects of changes in preferences in moral hazard problems

This study examines the effects of changes in an agent's preferences over income and effort on the principal's costs. The incentive cost is fundamentally affected by two factors: the income-effort marginal rate of substitution at the first-best wage, and the degree of absolute risk aversion around it. Thus, a resulting increase in the first-best wage has mixed effects because both factors are altered simultaneously. When the limited liability constraint does not bind and if the utility is concave with respect to the inverse of the marginal utility, a decrease in the marginal rate of substitution, an increase in the degree of risk aversion, and an increase in the first-best wage will raise both incentive and agency costs. However, when the constraint binds and if the marginal rate of substitution at the minimum payment decreases, an increase in the degree of risk aversion and an increase in the first-best wage will raise agency cost. Even if the first-order approach is not valid, the results still hold under the log-submodularity of the marginal cost.

Improving the Safety of Rural Communities: Safety Insurance Acts for Farmers and Fishers and Prevention of Work Accidents

The purpose of this study is to analyze the Act on Safety Insurance for Farmers and Fishers and Prevention of Work Accidents related to the agricultural production crisis and suggest some ways to improve safety insurance for farmers based on the act. The Safety insurance for farmers and its related law have various problems. First, due to the nature of policy insurance entrusted to the private sector, reverse selection and moral hazard problems occurred due to information asymmetry, and the difference in the real burden ratio of policy-holders depending on the subscription area caused regional equity problems. Second, the law stipulates causeism, but it is operated as enumerationism through the enforcement ordinance of the law and insurance terms and conditions. Third, there is no independent council on safety insurance for farmers, and there was also a lack of organization and interest in safety insurance for farmers within the Nonghyup. This study suggests three improvement ways. First, strengthening safety insurance for farmers as social security-type policy insurance. Second, promoting the integration of the Act on Safety Insurance for Farmers and Fishers and Prevention of Work Accidents and Agricultural and Fishery Insurance Act while separating agricultural and fishery parts. Third, establishing a comprehensive safety institution in the agricultural sector.

Financial inclusion and bank risk-taking: the effect of information sharing

We explore how information-sharing and financial inclusion influence bank risk in 84 countries from 1996 to 2020. Results show that greater information-sharing and financial inclusion lessen bank risk levels. The average bank's Z-score increases by 3.51–9.09%, attributable to enhanced information-sharing and higher financial inclusion. Inclusion-based deposit mobilization reduces bank probability of insolvency, suggesting that inclusion provides banks with cheap funding sources, reducing moral hazard problems and risky behaviors. Results remain robust across risk indicators and controlling for FinTech-based inclusion and COVID-19-induced risk. They support the hypothesis of increased social returns to transparency, information-sharing, and reaching out to financially excluded segments.

Leaving the darkness: The emergence of shadow banks

This paper studies the interaction between bank capital regulation, moral hazard and co-existence of traditional and shadow banks. Bank managers can choose between traditional banking and off-balance sheet special purpose vehicles (SPV), in a setup with deposit insurance and moral hazard. We first show that in the absence of SPV intermediation, capital requirements are ineffective at preventing the moral hazard problem originated by deposit insurance. We find that shadow banks can improve financial stability, when there is full information sharing. Finally, we analyze the case of neglected tail risk. We find that under such circumstances, the SPV will increase financial risk by exposing the system to extreme events.

Monitoring innovation

This paper examines the benefit of monitoring an agent who works on an innovative project of uncertain quality. The agent is asked to experiment to uncover the quality of the project. The agent has the ability to manipulate the principal's beliefs about the project quality because the effort of the agent may not be observable (moral hazard), and success may not be publicly observed (hidden information). The optimal timing of monitoring trades off the benefit of alleviating the moral hazard problem during the monitoring period (static effect) and a reduction of the agent's rent in periods before monitoring (dynamic effect). If the successful realization of the innovation is observed publicly, the static effect dominates, and monitoring is most beneficial at the beginning of the relationship. If success is private, the dynamic effect may become pivotal, and monitoring may be optimal at the end of the relationship.

The value of information about solar geoengineering and the two-sided cost of bias

ABSTRACT Solar geoengineering (SG) might be able to reduce climate risks if used to supplement emissions cuts and carbon removal. Yet, the wisdom of proceeding with research to reduce its uncertainties is disputed. Here, we use an integrated assessment model to estimate that the value of information that reduces uncertainty about SG efficacy. We find the value of reducing uncertainty by one-third by 2030 is around $4.5 trillion, most of which comes from reduced climate damages rather than reduced mitigation costs. Reducing uncertainty about SG efficacy is similar in value to reducing uncertainty about climate sensitivity. We analyse the cost of over-confidence about SG that causes too little emissions cuts and too much SG. Consistent with concerns about SG’s moral hazard problem, we find an over-confident bias is a serious and costly concern; but, we also find under-confidence that prematurely rules out SG can be roughly as costly. Biased judgments are costly in both directions. A coin has two sides. Our analysis quantitatively demonstrates the risk-risk trade-off around SG and reinforces the value of research that can reduce uncertainty. Key policy insights The value of reducing uncertainty about solar geoengineering is comparable to the value of reducing uncertainty about other key climate factors, such as equilibrium climate sensitivity. The benefits of research that reduces uncertainty about solar geoengineering may be more than a thousand times larger than the cost of a large-scale research programme. Under-confidence in solar geoengineering’s effectiveness can be as costly as over-confidence. The majority of the benefits of reduced uncertainty come from reducing climate damages rather than from slowing emissions reductions.

Who lost Ethiopia? The unmaking of an African anchor state and U.S. foreign policy

ABSTRACT In November 2020, Ethiopia descended into full-scale civil war which, owing to mass atrocities and regional intervention, metastasized into among the most acute humanitarian emergencies in the world. The violent fragmentation of state authority tarnished Ethiopia’s internationally sanctioned role as regional peacekeeper and developmental leader—an “anchor state” of the Pax Americana in the Horn of Africa. While acknowledging the complex, multi-dimensional origins of the conflict, this article examines how efforts by the U.S. government to reinvent the strategic relationship during the 2018–2020 political transition in Addis Ababa helped pave the road to war. We argue that U.S. policymakers provided largely unconditional support to Ethiopia’s new Prime Minister Abiy Ahmed, creating problems of moral hazard that encouraged confrontation between rival political forces. The story of U.S. engagement in Ethiopia in this period illustrates the perils of Washington’s efforts to rebalance fraught relations with its most important regional anchors.

Effectiveness of new safeguards and prohibitions to protect audit independence: an empirical research with auditors

ABSTRACT The EU has faced the moral hazard problem of auditors by protecting their independence in two ways, with the formulation of a general principle of independence, and with the implementation of a preventive and sanctioning framework of safeguards and incompatibilities. The latest EU Directive, which reformed the auditing profession, adopted and extended such measures. This research fills a gap in the literature by showing the perception auditors have of the benefits of this new regulatory framework to promote auditor independence. With this purpose, we developed a qualitative study using a questionnaire addressed to a sample of 192 auditors. Following structural equation modelling methodology (SEM), we obtained results showing that the new and more restrictive European regulation of personal and service incompatibilities has a positive effect and improves the perceived independence of auditors.

Information acquisition, selling effort and pre-order strategy

We study a firm's joint decision on pre-order strategy and information acquisition in the principal-agent framework. The firm may hire a sales agent to promote the pre-order opportunity and/or to boost spot demand. The market signal gleaned from the pre-order outcome is reported to the firm to refine the demand forecast. Considering the compensation contract design problem, we show that the interests of the firm and the sales agent can be aligned by the classical menu of linear contracts (MLC) mechanism. Comparing the performance of the models with one or both of the adverse selection and moral hazard problems, we find that the pre-order strategy dominates the traditional strategy without pre-ordering. The comparison results also show that under the pre-order strategy, a combination of the pre-selling and regular selling efforts may be outperformed by the pre-selling effort only.

Incentives under equal-pay constraint and subjective peer evaluation

We study a moral hazard problem for a firm with multiple workers where the firm cannot discriminate among workers' wages—equal-pay constraint—and evaluate workers' performances only through peers—subjective peer evaluation. More precisely, each worker privately chooses an effort level, which generates private signals received by his peers. The firm solicits peer evaluations, which are not verifiable. The wage must be equal across workers ex-post. We show that the firm can still provide incentives to put forth effort if (i) the signals are correlated conditional on joint efforts and (ii) higher efforts lead to higher correlation. The proposed wage scheme is optimal within the class of equal-pay contracts, and when workers are symmetric, it is optimal among all wage contracts.

Blessing or curse? Government funding of deposit insurance and corporate lending

A key policy to limit the possibility of bank runs is an explicit deposit insurance scheme, which can be either privately or government funded. Using syndicated loans from 63 countries during the period 1985–2016, we study the effect of government involvement in deposit insurance funding on price and non-price characteristics of loans. We show that changes from purely private-funded to either government-funded or jointly funded deposit insurance increase all-in-spread-drawn by approximately 4.6 %, further increase loan fees, decrease loan maturity, and increase the use of performance pricing provisions. Our findings are consistent with the moral hazard problem behind government-funded deposit insurance schemes.

New evidence of moral hazard: Environmental liability insurance and firms' environmental performance

AbstractThis paper provides novel evidence of the moral hazard problem in environmental insurance by investigating the effect of environmental liability insurance (ELI) on firms' environmental performance. Using the staggered adoption of ELI policies in China as a quasi‐natural experiment, we employ a difference‐in‐differences setup based on a comprehensive firm‐level data set. We find that the adoption of ELI policies significantly reduces firms' efforts in treating water pollution. The negative estimate indicates a moral hazard problem and is the opposite of the positive estimates found mainly in studies that focus on US firms. We further find that the negative effect is lessened for firms in strictly supervised regions and for firms with strong environmental awareness. This paper is one of the first to evaluate environmental insurance in developing economies and provides novel evidence on moral hazard in environmental liability insurance markets.

Ex Ante Moral Hazard in the Health Insurance Market in Indonesia

This paper will empirically examine the existence of ex ante moral hazard in health insurance market in Indonesia with respect to lifestyle choices such as smoking and obesity. A key challenge in understanding the moral hazard problem is endogeneity. Decisions regarding having insurance and lifestyle choices are arguably sequential, not simultaneous. Then, it is difficult to decide which one precedes the other. To address this problem, this paper uses a multivariate probit analysis. This paper uses three waves from the IFLS (Indonesian Family Life Survey) over 2000, 2007, and 2014, as these have information about insurance status, smoking behavior, and obesity condition. This paper finds evidence of the existence of ex ante moral hazard in health insurance for obesity of the head of household, but not for smoking. The multivariate probit regression shows that having health insurance increases the propensity of being obese. Using a wider sample, including all members of households, there is not sufficient evidence of the existence of ex ante moral hazard for either smoking or obesity. Surprisingly, the decisions between smoking and obesity are substitutes. This means that there are non-observable elements that increase the tendency to smoke, but reduce the propensity of being obese, and vice versa.