Dynamic Moral Hazard and Risk-Shifting Incentives in a Leveraged Firm

I develop an analytically tractable model that integrates the risk-shifting problem between bondholders and shareholders with the moral-hazard problem between shareholders and the manager. An optimal contract binds shareholders and the manager, and this contract’s flexibility allows shareholders to relax the manager’s incentive constraint following a “good” profitability shock. Thus, the optimal contract amplifies the upside and thereby increases shareholder appetite for risk shifting. Whereas some empirical studies find a positive relation between risk shifting and leverage, others find a negative relation. This model predicts a non-monotonic relation between risk shifting and leverage and can reconcile these contradictory empirical findings.

BANK RUNS: THE PREDEPOSIT GAME

We analyze in some detail the full predeposit game in a simple, tractable, yet very rich, banking environment. How does run-risk affect the optimal deposit contract? If there is a run equilibrium in the postdeposit game, then the optimal contract in the predeposit game tolerates small-probability runs. However, this does not mean that small changes in run-risk are ignored. In some cases, the optimal contract becomes—as one would expect—strictly more conservative as the run-probability increases (until it switches to the best run-proof contract), and the equilibrium allocation is not a mere randomization over the equilibrium allocations from the postdeposit game. In other cases, the allocation is a mere randomization over the equilibria from the postdeposit game. In the first cases (the more intuitive cases), the incentive constraint does not bind. In the second cases, the incentive constraint does bind.

THE FIRM AS A NEXUS OF STRATEGIES

This paper replaces the standard view of the firm as a nexus of contracts with a repeated game framework where input contributions and side payments are self-enforced. General production technologies and flexible transfers among team members are allowed. When an incentive constraint binds, input demand and output supply are influenced by the discount factor, the probability of exogenous team dissolution, and the aggregate value of outside options. When this incentive constraint does not bind, the firm maximizes profit in the usual way. I discuss examples involving the Cobb-Douglas technology, firms with a single residual claimant, and partnerships.

On Non-responsiveness in Adverse Selection Models with Common Value

In common value models, it is possible that the full information efficiency and the incentive constraint require the quantity of full and asymmetric information to move in opposite directions with the type. This conflict is called non-responsiveness. Most of those models share the features that when there is conflict, the optimal contract is pooling otherwise it is separating. In this note, we will show that, in fact, the robustness of the links between the conflict and separating contracts is not a general consequence of the common value models: it depends crucially on the assumption made in all those models that the principal's marginal benefit from trade with full information is not distorted by the presence of informational rents.