Moral Hazard Setting Research Articles

Dynamic Bonus Pools

ABSTRACT We study the properties of long-term bonus pools (BPs) with rollover provision in a multiperiod moral hazard setting, where the principal uses subjective information to privately assess the agent’s performance and the agent is protected by limited liability (LL). To provide incentives, the principal funds a multiperiod BP with a fixed payment that may be distributed over time to the agent and a third party. We find that the optimal long-term BP contract features performance targets that are contingent on past performance. Specifically, high subjective performance implies an easy target, and low subjective performance implies a difficult target. To implement the long-term BP contract, the principal provides nondichotomous performance reports. The study contributes to the literature that discusses the mechanisms that make subjective performance information useful for incentive contracting. JEL Classifications: D82; M52; M54.

Voluntary Disclosure, Moral Hazard, and Default Risk

We study a dynamic moral hazard setting where the manager has private evidence that predicts the firm’s cash flows. Bad-news disclosure is rewarded by a lower borrowing cost relative to the no-evidence case, whereas no disclosure leads to higher borrowing costs. For a given capital structure, disclosure reduces the firm’s default risk by lowering its pay-for-performance sensitivity. However, for a set of low-profitability firms, the anticipation of future disclosure of information by managers lowers both firm value and managerial rents at the financing stage because of a reduction in the firm’s initial liquidity. The model can reconcile the empirical evidence on the effects of providing earnings guidance, especially for loss firms. This paper was accepted by Bruno Biais, finance. Funding: S. Fu is supported by the Shanghai Pujiang Program and the Program for Professor of Special Appointment (Eastern Scholar) at Shanghai Institutions of Higher Learning [Grant 0900000182]. Supplemental Material: The data files are available at https://doi.org/10.1287/mnsc.2023.4860 .

Optimal incentive contract in continuous time with different behavior relationships between agents

Dynamic contracts with multiple agents is a classical decentralized decision-making problem with asymmetric information, it is usually discussed according to moral hazard and the behavioral relationship between agents. To do so, in this paper, according to behavior relationships between agents, we analyze continuous time optimal contracting in principal multi-agent moral hazard settings. According to stochastic optimal control theory, the optimal contract of the generalized principal-agent dynamic problem is given, the optimal behavior selection and incentive mechanism of agents are analyzed. The result shows that, in the two-agent model, the incentive effect of cooperative relationship is greater than that of competitive relationship; when they are in a cooperative relationship, with the more influential agent receiving higher pay; under multi-agent model, an increase in the number of agents reduces effort and rewards, this indicates that the team size has strict boundaries. The research conclusions can be applied to solve two kinds of principal-agent problems that the principal needs to motivate the agent to compete or cooperate in the actual social production and life.

Liquidity shocks and interbank market failures: the role of deposit flights, non-performing loans, and competition

Banks may be reluctant to remove bad loans from their portfolios during liquidity shortfalls, giving rise to a moral hazard problem. In this paper, we analyze how liquidity shortages affect the ability of the interbank market to provide liquidity in a moral hazard setting. We distinguish two types of liquidity shocks that arise due to a deposit flight (a contraction in the deposit supply) or to a cash-flow shock (an increase in the non-performing loans). We show that the source of a liquidity shortfall is the main determinant of the decision of banks to stop lending in the interbank market, rather than the extra amount of funds that banks need to cover. An increase in the non-performing loans has more adverse effects on balance sheets than a deposit flight. We also demonstrate that competition has a dual effect on financial stability. Interbank competition enhances financial stability by reducing the liquidity provision cost, whereas credit market competition worsens financial stability by inducing banks to take riskier profiles.

Technical Change, Moral Hazard, and the Decentralization Penalty

In a moral-hazard setting, we consider two modes of organizing a firm --- a Centralized mode and a Decentralized mode. In the Centralized mode, perfect monitoring ensures that the welfare-maximizing effort is chosen. In the Decentralized mode, monitoring is imperfect and a profit-driven Principal induces her favorite effort by appropriately rewarding the Agent. The loss in welfare due to decentralization is called the Decentralization Penalty..For certain common contract types, we study the behavior of the Decentralization Penalty in response to changes in the production technology. We find that as production technology improves, the Decentralization Penalty oscillates. The Penalty rises in all intervals where the Penalty changes continuously. After such an interval, there may be a sudden change in the Penalty, and, under reasonable assumptions on costs and expected revenues, the sudden change is a drop. While an improvement in monitoring technology always strengthens the case for the Centralized mode, advances in production technology may do the opposite.

Contracting with moral hazard, adverse selection and risk neutrality: when does one size fit all?

This paper studies a principal-agent relationship when both are risk-neutral and in the presence of adverse selection and moral hazard. Contracts must satisfy the limited-liability and monotonicity conditions. We provide sufficient conditions under which the optimal contract is simple, in the sense that each type is offered the same contract. These are: the action and the agent’s type are complements, and the output’s cumulative distribution function is such that the marginal rate of substitution between the action and the agent’s type is the same for each possible output realization. Furthermore, under the average monotone likelihood ratio property, the optimal contract is a call-option contract as in Innes (J Econ Theory 52(1):45–67, 1990). The results shed light on the fact that sometimes contracts are not highly dependent on individual characteristics as predicted in most pure moral hazard and pure adverse selection settings.

Optimal Quality Certification

Quality certification not only informs consumers but also stimulates producers to supply better-quality products. We study a problem of quality certification in a moral hazard setting. We show that, under standard assumptions, simple certification systems, such as quality assurance and pass-fail rules, are optimal. Our solution method involves interpreting the certification problem as a delegation problem. (JEL D82, L15)

Objective and subjective indicators in long-term contracting

We study the optimal compensation contract in a dynamic moral hazard setting with limited liability and two stages of production. At the end of the first stage, both an objective signal (publicly observed) and a subjective signal (privately observed by the principal) realize, and they are informative of the second-stage productivity. We show that in the optimal long-term contract, the two signals are used interactively with three notable features. First, whereas the objective signal is always used in the optimal contract, the subjective signal is used only if the realized value of objective signal is below a cutoff. Second, the solicited effort may exhibit an upward distortion (relative to the first best) for an intermediate region of the objective signal realizations. Third, the use of subjectivity varies with a number of factors such as the signal quality and the severity of the moral hazard problem.

Liquidity Shocks and Interbank Market Failures: The Role of Deposit Flights, Non-Performing Loans, and Credit Market Competition

Banks may be reluctant to remove bad loans from their portfolios during liquidity shortfalls, giving rise to a moral hazard problem. In this paper, we analyze how liquidity shortages affect the ability of the interbank market to provide liquidity in a moral hazard setting. We distinguish two types of liquidity shocks that arise due to a deposit flight (a contraction in the deposit supply) or to a cash-flow shock (an increase in the non-performing loans). We show that the source of a liquidity shortfall is the main determinant of the decision of banks to stop lending in the interbank market, rather than the extra amount of funds that banks need to cover. An increase in the nonperforming loans has more adverse effects on balance sheets than a deposit flight. We also demonstrate that competition has a dual effect on financial stability. Interbank competition enhances financial stability by reducing the liquidity provision cost, whereas credit market competition worsens financial stability by inducing banks to take riskier profiles.

The welfare costs of bank regulation by deposit rate ceilings

In a transparent and parsimonious moral hazard setting, various types of inefficiencies of deposit rate ceilings are identified. Welfare with ceilings may be lower than welfare without these and a more risky environment may render deposit rate ceilings impotent.

Contracting Theory with Competitive Interacting Agents

In a framework close to the one developed by Holmström and Milgrom [Econometrica, 55 (1987), pp. 303--328], we study the optimal contracting scheme between a principal and several agents. Each hired agent is in charge of one project and can make efforts toward managing his own project, as well as impact (positively or negatively) the projects of the other agents. Considering economic agents in competition with relative performance concerns, we derive the optimal contracts in both first-best and moral hazard settings. The enhanced resolution methodology relies heavily on the connection between Nash equilibria and multidimensional quadratic BSDEs. The optimal contracts are linear and each agent is paid a fixed proportion of the terminal value of all the projects of the firm. Besides, each agent receives his reservation utility, and those with high competitive appetite are assigned less volatile projects, and shall even receive help from the other agents. From the principal point of view, it is in the firm's interest in our model to strongly diversify the competitive appetite of the agents.

Moral Hazard, Dynamic Incentives, and Ambiguous Perceptions

This paper considers dynamic moral hazard settings, in which the consequences of the agent's actions is not precisely understood. In a new continuous-time principal-agent model with drift ambiguity, the agent's unobservable action translates to drift set for the diffusion processes that describe evolution of output. The agent and the principal has symmetric imprecise information about the technology, and both seek robust performance from a contract in relation to their respective worst-case scenarios. We show that the optimal long-term contract aligns the party's pessimistic expectations and broadly features flattening of the high-powered incentives. Methodologically, we provide a tractable way to formulate and characterize optimal long-run contracts with drift ambiguity. Substantively, our results provide some insights into the formal link between robustness and simplicity of dynamic contracts, in particular that presence of ambiguity flattens high-powered incentives.

Moral hazard with non-additive uncertainty: When are actions implementable?

We provide sufficient conditions on the information structure for implementing actions in a moral hazard setting when Agent has non-probabilistic uncertainty. For a finite action space, under three well-known formulations of Agent’s ambiguity attitude, contracts that partition the outcome space in two parts, and are piecewise constant on each part, are enough to implement an action.

Objective and Subjective Indicators in Long-term Contracting

We study the optimal compensation contract in a dynamic moral hazard setting with limited liability and two stages of production. At the end of the first stage, both an objective signal (publicly observed) and a subjective signal (privately observed by the principal) realize, and they are informative of the second-stage productivity. We show that in the optimal long-term contract, the two signals are used interactively with three notable features. First, whereas the objective signal is always used in the optimal contract, the subjective signal is used only if the realized value of objective signal is below a cutoff. Second, the solicited effort may exhibit an upward distortion (relative to the first best) for an intermediate region of the objective signal realizations. Third, the use of subjectivity varies with a number of factors such as the signal quality and severity of the moral hazard problem.

Voluntary disclosure under dynamic moral hazard

We study a dynamic moral hazard setting where the manager has private ev- idence that predicts the firm's cash flows. When performance is low, bad news disclosure is rewarded by a lower borrowing cost relative to the no-evidence case. In contrast, no disclosure is associated with higher borrowing costs. On net, disclo- sure weakens the relation between cash incentives (or stock values) and short-term performance, which lowers the firm’s default risk on path. However, the expecta- tion of future disclosure might increase the optimal initial level of debt, to a point where the firm’s default risk actually rises relative to the no-evidence case.

The trade-off between profitability and outreach in microfinance

The focus of this paper is on the alleged shift of microfinance programs from targeting poor borrowers towards wealthier clients and profitability. In a simple moral-hazard setting, we determine the equilibrium financial contracts offered by a for-profit and a not-for-profit microfinance institution (MFI). We show that: i) with a for-profit MFI, mission drift does not necessarily occur if borrowers are offered a combination of individual and joint liability contracts; ii) with a not-for-profit MFI, poor individuals are never crowded out by wealthier entrepreneurs.

Incentive Contracts and Downside Risk Sharing

This paper seeks to characterize incentive compensation in a principal-agent moral hazard setting in which the principal is prudent, or downside risk averse, as many situations (such as that of a patient in hospital or a regulator dealing with food safety) suggest she should be. We show that optimal incentive pay should then be ‘approximately concave’ in performance, the approximation being closer the more downside risk averse the principal is compared to the agent. Limiting the agent’s liability would improve the approximation, but taxing the principal would make it coarser. The notion of an approximately concave function we introduce here to describe the pay-performance relationship is relatively recent in mathematics; it is intuitive and translates into concrete empirical implications, notably for the composition of incentive pay. We also clarify which measure of prudence - among the various ones proposed in the literature - is relevant to investigate the tradeoff between downside risk sharing and incentives.

Dynamic costs and moral hazard: A duality-based approach

The marginal cost of effort often increases as effort is exerted. In a dynamic moral hazard setting, dynamically increasing costs create information asymmetry. This paper characterizes the optimal contract and helps explain the popular yet thus far puzzling use of non-linear incentives, for example, in sales-force compensation. The result is obtained by complementing the standard dynamic program with a novel dynamic dual formulation. The dual program is monotonic and sub-modular, providing stronger results, including a proof for the sufficiency of one-shot deviations.

Dynamic Costs and Moral Hazard: A Duality Based Approach

The marginal cost of effort often increases as effort is exerted. In a dynamic moral hazard setting, dynamically increasing costs create information asymmetry. This paper characterizes the optimal contract and helps explain the popular yet thus far puzzling use of non-linear incentives, for example in sales-force compensation. The result is obtained by complementing the standard dynamic program with a novel dynamic dual formulation. The dual program is monotonic and sub-modular, providing stronger results, including a proof for the sufficiency of one shot deviations.

Under-Delegation in Case of Pure Moral Hazard: Evidence from the Laboratory

In case of a conflict of interest between principals and agents, laboratory experiments have demonstrated the existence of a "control premium", i.e. a willingness to accept lower expected payoffs for keeping control. We analyze delegation decisions in a pure moral hazard setting without conflicts of interest, and show that there is a pronounced tendency to under-delegation. This is in line with the literature on over-monitoring in settings with conflict of interest, and reinforces the view that a positive control premium is a widespread and robust phenomenon. Besides, we find that women are less susceptible to moral hazard, defined as the performance if working for oneself compared to working for a principal. This gender difference is not reflected in the delegation behavior of principals.