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Half of the jobs in the U.S. feature pay-for-performance. We study nonlinear income taxation in a model where such contracts arise in private labor markets that are constrained by moral hazard frictions. We derive novel formulas for the incidence of arbitrarily nonlinear reforms of any given tax code on both the mean of earnings and their sensitivity to performance. We show theoretically and quantitatively that, following an increase in tax progressivity, the higher performance-sensitivity caused by the crowding-out of insurance provided by firms is almost fully offset by a countervailing “performance-pay effect” driven by labor supply responses. As a result, earnings risk is hardly affected by policy. We then turn to the normative analysis of a government that levies taxes and transfers to redistribute income across workers with different levels of uninsurable productivity. We find that setting taxes without accounting for the endogeneity of private insurance is close to optimal. Thus, the common concern that standard models of taxation underestimate the cost of redistribution is, in the context of performance-based compensation, overblown.

We study the effects of transparency disclosures on the risk culture, corporate culture, and performance of U.S. banks. Using stress test regulation, textual analysis, and a regression discontinuity design, we exploit the regulation's quasi-experimental properties around the bank-size policy thresholds. We find that stress-test banks substantially improve their risk and corporate cultures. Strong risk culture banks further reduce their risk densities, risky loans, and costs of debt while increasing profitability. Surprisingly, these effects do not exist among the subset of banks with strong corporate culture only. When examining banks with both strong risk and corporate cultures, the effects switch signs showing evidence of moral hazard. Our findings highlight the differentiating role of risk culture and the restraining impact organizational culture has in mitigating risk.

We compare a Blockchain-based Supply Chain Finance system with traditional bank-based Supply Chain Finance solutions, using a three-tier supply chain model. Our model features financing frictions due to moral hazard with respect to product quality and dynamic updates of collateral-asset-value forecasts. The key advantage of a Blockchain-based system is its ability to create claims to collateral assets at higher supply chain tiers, while a bank-based system allows only creating claims to the immediate buyer's collateral asset. Interestingly, despite this advantage, a Blockchain-based system does not emerge as the dominant financing choice, even if the higher-tier buyer has the same profit margin and the same parameters of the collateral asset process as the immediate-tier buyer. We identify two causes of this surprising result: risk spillover from the higher-tier to the immediate-tier buyer and accumulation of more noise in the collateral asset when using the higher-tier buyer's collateral asset for financing. We provide conditions for the Blockchain-based system to be equally attractive and conditions for the Blockchain-based system to be preferred.

Teamwork is central to many organizations, especially in knowledge-intensive and service industries. Yet, the reality of many teams is that not everyone contributes equally. Often one person single-handedly carries out a project's execution because it is more efficient or, alternatively, due to interpersonal dynamics. To disentangle these two effects we consider a stylized principal-agent model of co-production and characterize the equilibrium operating modes when the principal chooses ex-ante how output is to be split. The principal and the agent may have different costs of effort (capabilities) and incentives (as set by the principal). Their efforts can be complementary or substitutable and participation in the project is voluntary. We find that, due to double moral hazard and the principal's desire to capture value, the principal works alone too often and that small changes in effort coupling may lead to abrupt changes in incentive structure and operating modes. Our stylized model explains why managers tend to micro-manage or under-delegate, why different phases of a project might involve different leadership styles, and how advances in technology can radically transform service delivery.

We document the effects of higher borrowing cost on private firms by exploiting a novel quasi-experiment and a unique and comprehensive dataset from Sweden. In June 2010, the central bank of Sweden increased the repo rate unexpectedly and exposed firms with long term loans maturing right before or after the hike to different cost of borrowing. Consistent with the debt overhang theory, we find that higher cost of borrowing has a significant negative effect on investment, and more for highly levered firms. Contrary to the risk shifting theory, we find no evidence that distressed firms engage in activities that are riskier ex-post.

We investigate whether financial contract terms alter individuals’ risk-taking behavior under a moral hazard framework. Exploiting (a) the contractual-level data of automobile insurance, and (b) a unique institutional reform that gives more pricing freedom to insurers, we discover a significant decline in the likelihood of accidents (and those involving injuries or deaths) after the premium becomes more sensitive to past performance. The effects are stronger for riskier drivers, and in regions with a more dangerous road condition. The evidence suggests that contracts with a more flexible premium scheme of rewards and penalties induce less risky behavior, mitigating moral hazard.

This paper explores banks' behaviour in the five years prior to a firm's financial distress. We construct a model of bank competition where new banks will often refinance loans that a firm's current banks do not want to renew. The model predicts that existing banks will be more frequently able to exit their loans if the firm has collateral or a good rating. Using bank–firm level credit data we test this model and document that indeed, banks with long standing relationships strategically terminate lending relationships at losses at the expense of less informed banks, well before those firms approach default. The number of banks continuously increases until about one year before the default, allowing inside banks that have been present in the firm’s capital for a long time to reduce their exposure. As predicted this effect is stronger for firms with a good credit rating prior to bankruptcy.

The decision of HMG to cease UKEF support for the fossil fuel energy sector is a signal achievement in global climate finance. It demonstrates the ambition of the UK – post-Brexit, and post-pandemic – to lead international on climate action. In order to deliver on that ambition important practical issues require consideration. First, how can the decision be implemented such as to maximise its credibility and impact, both domestically and internationally? A central issue to implementation is the imperative to avoid the regulatory displacement of finance from UKEF to other UK public finance entities, such as CDC group and PIDG. More ambitiously, if the UK and other similarly situated jurisdictions are to genuinely become a Paris aligned low carbon economy and society, there is a need to understand the role that GGR (greenhouse gas removal technologies) have to play in the process. A complex matter involving climate finance, but also moral hazard and innovation policy, GGR will be a central plank to going beyond ‘do no harm’ and delivering transformation.

This article studies future equity financing in a continuous-time principal-agent setup whereby career concerns generate moral hazard tension. Our framework admits precise closed-form expressions. The higher firm value leading up to conversion, the fewer equity investors attain and the less risk the entrepreneur takes. We implement the contract using a convertible note with a valuation cap, that if set too high, developing innovation becomes suboptimal. Lastly, we introduce the implied probability of success: a novel measure allowing for risk comparison across different innovative technologies. We demonstrate its use to empirically estimate investors' skill and correct selection bias in realized returns.

We examine a general equilibrium dynamic economy in which each firm hires a manager who privately observes cash flows and can fire him after poor performance, generating costs to both parties. The contract is terminated when the manager's continuation value reaches his compensation at another firm net of his search cost. The unique competitive equilibrium features overcompensation, short-termism, and excessive executive tenure. When a firm increases executive pay, it increases the cost to other firms to retain their managers, in turn forcing them to raise and front-load their compensation packages. Inefficiencies decrease with the firm's discount rate and increase with the manager's discount rate, the termination cost to the firm, and the proxy for moral hazard. An increase in the search cost to the manager increases social welfare. In the competitive equilibrium, the private optimal contract can be implemented via inside equity relinquished by the manager upon moving to a new firm. Optimal corporate and income tax schedules can generate the social planner's allocation.

We study SPACs in a continuous-time delegated investment model. Our model is built upon three unique features of SPACs: the sponsor and the investor are only partially aligned, a SPAC has a short time horizon, and the investor has the final control over investment approval. Due to the misalignment in incentives, the sponsor has an increasing incentive to propose unprofitable projects to the investor; in response, the investor exerts more stringent screening based on her information. Although the screening helps curb the sponsor’s moral hazard, it also dampens the disciplining effect of partial alignment in incentives. When the investor’s information is sufficiently noisy, the second effect dominates, so giving the investor the control over investment approval reduces everyone’s welfare. This adverse effect is more pronounced if entrepreneurs’ strategic choices of SPAC or the sponsor’s strategic choice of effort are considered. We find that introducing public assessment and making the investor’s control right contingent on it may benefit both parties. We also explore whether a SPAC should be allowed to continue after the current project is disapproved by the investor.

We study the impact of changes in recourse legislation on mortgage defaults. Romania provides us with an ideal experimental setting to identify this impact. Using a large dataset of mortgage loans granted between 2003 and 2016, we exploit an exogenous variation in Romanian recourse policy and analyze the behavior of borrowers with mortgages issued under a recourse regime after a change in policy limited lender recourse. We find robust evidence that eliminating penalties for default raises the delinquency probability of existing borrowers, particularly those traditionally considered least likely to default. Our findings highlight the ex-post effects of a switch from a creditor-friendly to a debtor-friendly recourse policy. Broadly, our results point to the importance of assessing borrowers’ default incentives before introducing recourse legislation with retroactive applicability.

This paper empirically examines the Capital Purchase program (CPP) under TARP that was usedby the U.S. government to bail out distressed banks with equity infusions. We hypothesize that a feature of the CPP, namely the ability of the government to appoint directors on the assisted bank’s board in case it missed six quarterly dividend payments, was a governance intrusion that banks would wish to avoid. Therefore, it would address both (i) the ex ante moral hazard that banks would take actions that increased the likelihood of a future government bailout as well as (ii) the ex post moral hazard that banks would undertake actions after receiving bailout funding that would increase the government’s risk exposure. We find evidence consistent with this hypothesis: in the empirical distribution of missed payments there is a sharp discontinuity at five and the probability of a sixth missed payment after missing five payments is sharply lower than the other transition probabilities. The appointment of government directors improves the bank’s profitability and reduces its risk. As a special case, the firing of Citicorp’s CEO in the third quarter of 2012 after the appointment of new directors on its board, pursuant to government participation in its common equity, induced a sharp exodus of assisted banks from the CPP.

I develop a dynamic principal-agent framework to examine the role of accounting information in a long-term contracting relationship with uncertainty over fundamental performance in which intertemporal incentives and termination are jointly determined. Learning and the reversal property embedded in the accounting performance measurement system gives rise to an accounting-driven demand for long-term incentives. Measurement precision directly influences the performance-based vesting behavior of these incentives over the course of the contracting relationship. Furthermore, equilibrium manipulation of the accounting report becomes increasingly positive as the agency approaches termination because such a policy reduces the chance of inefficient termination. My framework allows for falsifiable predictions regarding the relationship between the properties of accounting measurement and the evolving nature of incentives over the manager's tenure, managerial risk-taking activity, and managerial turnover.

I provide a novel framework for machine learning models to ingest quantified soft information during the life of a loan, using cutting-edge natural language processing techniques on salient unstructured text. This soft information, from servicer call transcripts, is not restricted to mere positive/negative sentiments and provides efficiency and alleviates the information asymmetry between the lender (and/or issuer) and the borrower. Proprietary servicer comments are hardly accessible and offer the soft in-formation for real-time delinquency status of the mortgages. I investigate whether the special servicer invoked by the investor can utilize the valuable comments from the master servicer. The time-varying soft information about the borrower’s financial condition, health of the loan and the property condition from these master servicer comments renders the predictive power and has asset pricing implications. Given this valuable information, the special servicer may choose to use this information, as I anecdotally see with several private equity investors. The well-known unresolved conflict of interest between the master and special servicers can be resolved, thereby reducing moral hazard and increasing efficiency and transparency.

The unobservability of the borrower's action is a major reason that smaller enterprises face high financing costs and credit rationing. We show that bank loans fully monitored by blockchain allow poor firms with low working capital to eliminate this agency cost. Interestingly, this is achieved by financing all production using fully monitored debt and leaving all internal capital unused; because the use of private, unmonitored internal capital creates unobservability whereas all-debt financing provides full transparency of operations. In contrast, rich firms find it costly to eliminate moral hazard via transparency and they prefer a mix of internal capital and unmonitored debt to finance production. We identify the working capital level at which a firm is indifferent between using all-debt or mixed financing for production. A poor firm with working capital below this indifference level strictly prefers all-debt financing and a rich firm above the level strictly prefers a debt-equity mix. We extend our results to a supply chain and show that the entire supply chain benefits from the use of monitored debt by an individual firm. The "inefficient" bankruptcy cost can create value under blockchain by mitigating the deadweight loss due to decentralization.

Problem Definition: Interest subventions (subsidies) on crop loans are a common feature of rural credit markets in developing countries. This study evaluates the impact of an interest subsidy program for the Kisan Credit Card (KCC) scheme - India’s flagship program to provide short-term agricultural credit. The objective behind giving interest subsidies is two-fold – increasing access to credit and improving loan repayment rates (by offering affordable credit), and is therefore regarded as a win-win for the lender and the borrower. However, the effectiveness of this policy has been debated. Moreover, academic research which causally evaluates the impact of such interest subsidy programs is limited. Methodology/Results: We use a unique transaction-level dataset from a large public sector bank to study a natural experiment in which the state of Odisha introduced a new subsidy program for its farmers in 2013-14. We use a combination of matching and difference-in-differences techniques, utilizing the nuances in the policy implementation. Further, we capture the heterogeneous impact of the policy on new and experienced borrowers. With regard to access to credit, not only do we observe a substantial increase (35%) in new loans but also a 20% decrease in the overall loan amount, indicating increased breadth and depth of access. As against the standard economic theories which posit that interest rate reduction leads to a higher repayment rate on loans (by addressing adverse selection and moral hazard problems), we observe a reduction in odds of repayment to 0.36-0.75 times its original value. Managerial Implications: Our impact assessment reveals unintended consequences of the interest subsidy and will let policymakers evaluate if the access-repayment trade-off is acceptable in their context. Further, the counter-intuitive findings shed light on the importance of various operational and behavioral aspects of the agricultural lending ecosystem, which need to be considered to craft effective, i.e., win-win credit policies.

We study dynamic partnerships where the output evolves stochastically, each player can exit at any time, and players who have exited continue to enjoy some benefits of the partnership. We analyze the contagion of defections and show that severe contagion facilitates cooperation among players by deterring free-riding. The unique equilibrium features a curse of productivity, namely, a larger output of the partnership may harm all players by exacerbating free-riding. Another main finding is that a partnership's ability to sustain cooperation is non-monotonic in its size.

A firm delegates search for a worker to a recruiter. Productivity is uncertain prior to hire with recruiter beliefs characterized by an expectation and variance. Delegation occurs using a refund contract which is common in the industry. We analyze how delegation in this setting shapes search behavior and the composition of hires. We demonstrate that delegation is theoretically equivalent to making the search technology less accurate. This generates inefficiency: search effort and social surplus are lower under delegation than in the first-best benchmark. We show this inefficiency is driven by moral hazard with a multitasking flavor. The recruiter wastes search effort finding low variance workers at the expense of high expectation workers. As a result, as workers become more homogeneous with respect to productivity variance, delegation becomes more efficient. Our model provides a microfoundation for variance-based statistical discrimination.

We examine the relation of active options market trading and the (in)efficiency of corporate investment in terms of deviation from optimal investment levels. Past research considers the volume of options trading as contributing to firms’ informational efficiency. Investment efficiency is partly driven by information asymmetries between firm managers and capital providers, aggravating moral hazard concerns. We test whether the enhancement in firms’ information environment associated with higher volume of options trading activity is positively related to optimizing investment at the firm level. Our results indicate that the volume of options trading by firms is positively and significantly associated with firm-level investment efficiency. This relation is associated with the enhancement in the firms’ information environment stemming from active options trading. Overall, our findings suggest that the managerial skills associated with active trading in derivatives markets also benefit firms’ investment decisions through enhancing the optimal allocation of firm resources and investment efficiency.

We study whether and how sell-side research affects the agency issue between asset managers and their clients. We show that even if sell-side research alone does not generate conflicts of interest, it can exacerbate the moral hazard problem of asset managers. Imposing transparency on the use of sell-side research, as the recent regulation MiFID II does, helps investors alleviate this negative effect. Forcing the managers to absorb sell-side research costs has a similar effect. Our model explains the empirical findings on how transparency affects the supply of buy-side research, the demand for and the quality of sell-side research. This paper contributes to improving the organization of the asset management industry and the debate on recent regulations on sell-side research.

The modern financial system is plagued by misaligned incentives that allow some firms to extract distributive profits, and direct wealth transfers in their favor, without producing anything of value, or improving society with enhanced employment or socially useful innovation. Many modern financial products and activities serve no underlying economic or productive purpose. The system is creating market intermediaries of astounding size, power, profitability, and economic and regulatory policy influence. Some financial firms expressly profit from heightened interconnection and complexity, while others benefit directly from increased volatility. Yet we all bear the costs of this evolved financial system when it unravels due to its interconnectedness with the real economy, and our increased reliance on markets. This article advocates for a financial system that is de-financialized, de-complexified, more transparent, and better orientated to productive ends in a way that benefits all of society, not just the firms who reap asymmetrical payoffs in a complex system, intermediate capital, create financial products, or run the plumbing in a system that ultimately serves them best. This article gives support to Hyman Minsky’s “money manager capitalism” hypothesis by showing how the financial system has evolved since the 2008 crisis because of misaligned incentives. In support of this contention the article profiles numerous post-crisis trends and events in financial markets where misaligned incentives emerge, including moral hazard in debt origination, how some financial firms benefit from volatility; the real winners of the Game Stop “meme stock” saga; problems from price dislocations in credit exchange traded funds (ETFs) during the coronavirus pandemic crash; conflicts in the construction and composition of indices; market disruption from volatility-linked exchange traded products (ETPs); misaligned incentives in special purpose acquisition companies (SPACs) and evolved private equity (PE) business models; fragilities in pension administration; environmental, social, governance (ESG) opacity and greenwashing in investment funds; and governance conflicts from economic and proxy voting power of mega-asset managers.

This paper studies the optimal insurance design from the perspective of an insured when there is possibility for the insurer to default on its promised indemnity. Default of the insurer leads to limited liability, and the promised indemnity is only partially recovered in case of a default. To alleviate the potential ex post moral hazard, an incentive compatibility condition is added to restrict the permissible indemnity function. Under the actuarial premium principle and mean-variance preferences of the insured, we derive the explicit structure of the optimal indemnity function through the marginal indemnity function formulation of the problem. It is shown that the optimal indemnity function depends on the first and second order conditional expectations of the random recovery rate. The methodology and results in this paper complement the literature regarding the optimal insurance subject to the default risk and provide new insights on problems of similar types. Moreover, we also apply the techniques in this paper to the case of additive background risk, which yields an alternative proof of the main result of Chi and Tan (2021).

Problem: Initial Coin Offerings (ICOs) are an emerging form of crowdfunding for blockchain-based startups. While ICO design varies greatly in practice, many service-based platforms (e.g., Ethereum), use "uncapped" structures that forego limits on token supply, subjecting early investors to dilution risk. In this paper, we examine the conditions under which such ICOs are optimal and provide guidance for their optimal design. Relevance: Despite their popularity in practice, uncapped ICOs are understudied and not as well understood as their capped counterparts. Methodology: We model game-theoretic interactions among various stakeholders in an infinite-horizon setting with network effects, taking account of operational details. Results: We show that uncapped ICOs weakly dominate capped ones in the context of service platforms. In terms of design, a platform commission and regulation are generally "substitutes" when it comes to overcoming moral hazard, but can also be combined to make ICOs more accessible, especially for platforms with high initial setup costs. ICO accessibility can also be increased by employing a dual token offering (security & transaction tokens), at the cost of reduced expected profit. Implications: The paper provides a theoretical underpinning for the use of uncapped ICOs in practice. At a high level, it shows that ICOs succeed more easily in the presence of regulation, and platforms with low (high) setup costs should preferably issue utility (dual token) type ICOs.

We study a dynamic moral hazard problem in which a bank originates a pool of loans that it sells to competitive investors via securitization. The bank controls the default risk of the loans by screening at origination and monitoring after origination, but it is subject to moral hazard. The optimal contract between the bank and investors can be implemented via a time-decreasing stake within the loan pool, so the bank's monitoring incentives decrease and default risk increases over time. We find that screening and monitoring have positive incentive synergies and are complements. Credit ratings distort incentives, potentially increasing credit risk, and are particularly beneficial for high quality and short-maturity loans.

We study a screening model in which agents can under-utilize goods. We characterize implementable and optimal contracts and show that, whenever the principal values usage instrumentally, the optimal menu involves multi-part tariffs with tiers of zero marginal prices. We apply our results to study the pricing of digital goods which naturally feature usage-based revenue and unpunishable under-utilization, such as social media, news, and content streaming. We derive comparative statics that map the structure of usage-based revenues to familiar multi-part pricing schemes (premium plans, free trials, and free products) and study the welfare implications of technological progress in targeted advertising. We show how partial contractibility of usage generates an endogenous separation between "users" and "employees" of digital platforms.

We investigate the impact of accrual accounting on contracting and the characteristics of optimal accrual policies in a continuous-time moral hazard framework. An agent who controls unobservable fundamental performance is compensated via a contract written on cash flows, which contain timing errors, and accounting earnings, which correct timing errors at the expense of introducing measurement errors. Deferred incentives and accruals are substitutes in solving the incentive problems created by cash flow timing errors, and accruals dominate deferred incentives as measurement becomes more precise. If cash flows and earnings are sufficiently informative, then accruals are the primary control mechanism late in the agency relationship when the most efficient accrual policy is time-invariant and standardized - it is driven by measurability rather than agency-specific parameters. By contrast, deferred incentives are the primary control mechanism early in the agency relationship, when the most efficient accrual policy changes over time, is non-standardized, and corrects fewer timing errors than the standardized policy. Overall, our model links optimal long-term incentives to accrual accounting policies and generates novel predictions about dynamic contracting and accounting practices.

General partners (GP) are sometimes paid on a deal-by-deal basis and other times on a whole-portfolio basis. When is one method of payment better than the other? I show that when assets (projects or firms) are highly correlated or when GPs have low reputation, whole-portfolio contracting is superior to deal-by-deal contracting. In this case, by bundling payouts together, whole- portfolio contracting enhances incentives for GPs to exert e ort. Therefore, it is better suited to alleviate the moral hazard problem which is stronger than the adverse selection problem in the case of high correlation of assets or low reputation of GPs. In contrast, for low correlation of assets or high reputation of GPs, information asymmetry concerns dominate and deal-by- deal contracts become optimal, as they can efficiently weed out bad projects one by one. These results shed light on recent empirical findings on the relationship between investors and venture capitalists.

In this paper, we investigate the economic and behavioural factors affecting a firm’s optimal choices in the creation and management of its supply chain, and the resulting output in terms of economic value creation and social/ethical or environmental performance, defined as ‘public value’ (Bozeman, 2002; Moore & Bennington, 2011). Furthermore, we consider the effects of management’s extrinsic and intrinsic motivations, and the resulting alignment or conflicts between management and shareholders. Our game-theoretic analysis models how firms and their suppliers weigh up maximisation of economic value with delivering any level of ‘public value’ (social or environmental outcomes). Included are the risk of reputational damage destroying trust, and the economic penalty related to a public value outcome. Our model shows that an alignment in social preference across the supply chain is important, as is consumer pressure. This is equally true when customers (or investors) are motivated solely by cost reduction or profit maximisation. In making its choices, the focal firm faces twin pressures from within the supply-chain as to whether they too will act to maximise economic value or public value, and externally (from ethical/socially-minded consumers). We model the impact of values alignment and misalignment between firm, supplier and customer, and the threat of moral hazard, providing an application of behavioural OR in sustainable supply chain management. This helps to theorise the drivers for irresponsible behaviour that can lead to significant reputational damage and subsequent negative economic performance.

Successive welfare-maximizing governments must decide whether to implement an affirmative action policy. This affirmative action policy is purported to improve the performance distribution of a targeted group (minority or otherwise), although this improvement becomes trivial when the policy is implemented over a long period of time. Employers pay workers according to their expected productivity, but without (perfectly) observing whether they benefited from affirmative action or not. This has a depressing effect on the wages of non-beneficiaries (whether or not they belong to the targeted group), leading in turn to a feeling of injustice. We find that governments perpetually choose to implement an affirmative action policy, even though the overall feeling of injustice is worse than the purported beneficial effect on the performance of the targeted group (which becomes marginal over time). The explanation we propose is based on a novel moral hazard argument: Each government's actual policy decision is not (perfectly) observed by market participants and thus has no direct effect on wages. Governments therefore do not internalize the depressing effect of an affirmative action policy on wages when choosing to implement it. This outcome is in sharp contrast with a first-best, welfare-maximizing policy plan, in which governments choose to end affirmative action after a certain number of periods, when the purported improvement in the performance distribution of the targeted group becomes small enough.

While kinks are prevalent in tax and transfer systems, the fiscal revenue and behavioral responses are not fully understood. In disability insurance (DI) programs, for instance, kinks help balance the moral hazard effects from the induced entry with the provision of work incentives for recipients who regain their ability to work. Using quasi-random variation in kink points in the benefit schedule for Norwegian DI recipients, I identify intensive and extensive margin earnings responses to the implicit tax on earnings as DI benefits are phased out above the kink. To identify the intensive margin responses, I implement a non-parametric bunching design that does not require functional form assumptions or deciding an excluded region around the kink. Responses correspond to an earnings elasticity with respect to the implicit net-of-tax rate of about 0.18. Using a regression discontinuity design, I further show that the kink in the benefit schedule induces significant responses at the extensive margin. I use the estimated earnings responses to evaluate how the benefit offset affects program costs, and find that relaxing the benefit offset reduces public expenditures only if program entry is very inelastic. My findings speak to recent policy-proposals aiming to improve work incentives of DI recipients.

One of the main results of “Robust Contract Designs: Linear Contracts and Moral Hazard” by Yu and Kong (2020) is Proposition 4, which states that the optimal robust contract with a piecewise linear concave agent utility only consists of progressive fixed payments and linear rewards with progressive commission rates. In this note, we construct a counterexample showing that this result is wrong.

We study the impact of different dimensions of banks' experience on the extent of banks' moral hazard in loan markets. Using rich U.S. corporate loan-level data, we find that banks' prior experience with borrowers and co-lenders reinforces their monitoring incentives. Banks' sectoral experience, in contrast, appears to dilute monitoring incentives, calling for a larger lead share in the lending syndicate. In cross-sectional tests, we unpack experience into different dimensions and study to what extent the various components of lenders' experience improve credit market outcomes. The key to our identification strategy is that we exploit variation in experience for the same bank at a given point in time across firms, sectors and other banks. In addition, bank mergers are used as an instrument to identify exogenous shocks to the stock of bank's experience.

Using credit register data for loans to Italian firms we test for the presence of asymmetric information in the securitization market by looking at the correlation between the securitization (risk-transfer) and the default (accident) probability. We can disentangle the adverse selection from the moral hazard component for the many firms with multiple bank relationships. We find that adverse selection is widespread but that moral hazard is confined to weak relationships, indicating that a strong relationship is a credible enough commitment to monitor after securitization. Importantly, the selection of which loans to securitize based on observables is such that it largely offsets the (negative) effects of asymmetric information, rendering the overall unconditional quality of securitized loans significantly better than that of non-securitized ones. Thus, despite the presence of asymmetric information, our results do not accord with the view that credit-risk transfer leads to lax credit standards.

Between 1909 and 1922 a private deposit insurance company coexisted with the state-sponsored deposit insurance program in Kansas. This paper documents its development using primary sources. In addition, it examines if affiliation with the private deposit insurance (i) had an effect on risk-taking and the probability of failure; (ii) increased confidence among depositors, and (iii) was influenced by a neighboring bank’s membership in the state’s deposit insurance. We find that affiliation with the private deposit insurance did not affect a bank’s likelihood of failure, although smaller national bank members did increase risk-taking. The evidence does not support the hypothesis that the company enhanced depositor confidence. Lastly, we do find strong evidence that a bank’s decision to join the private deposit insurance was influenced by neighboring banks’ affiliation with the Kansas deposit insurance program.

We study the labor supply and consumption responses to cash assistance delivered through the Temporary Assistance to Needy Families (TANF) Program in the United States. Exploiting a sharp increase in cash benefit generosity for low-income single-parent families in New Hampshire due to a legislative revision to payment calculations, we implement difference-in-differences and triple-differences to estimate the impacts of greater benefits on work behavior as well as on food expenditures and food security. Our results suggest that more generous cash assistance reduces labor supply among likely TANF-eligible individuals, but also increases household food spending and reduces the incidence of food insecurity. Our findings speak both to the moral hazard costs and to the standard-of-living improvements associated with expanded cash assistance in an era in which cash welfare is at historically low levels, is time limited, and imposes work requirements.

The effects of asymmetric information are often difficult to detect empirically, such as in insurance settings. We show that allowing for reference-dependent preferences can assist with this empirical challenge. Using detailed auto insurance claims data, we show that policyholders exhibit ex-post moral hazard by exaggerating their damage claims in a manner consistent with reference-dependent preferences. Consistent with our model of reference-dependent claims, we find stronger reference-dependent behavior among policyholders with higher premium levels and low risk policyholders. Also consistent with the model, policyholders are more reference-dependent in their first claims than in subsequent claims, and in the second half of the coverage year compared to the first half. Specifically, the detected reference point is the amount of the original premium paid - in other words, in claiming their accident damages, policyholders seek to claim back the original price paid for their insurance. The pattern does not hold for other potentially salient levels of damages, nor is it consistent with an inclination to merely inflate claims more generally. Since damage claims can only be very precisely manipulated by the policy holder after an accident has occurred, the findings can be attributed primarily to ex-post moral hazard rather than adverse selection or ex-ante moral hazard. Furthermore, the pattern exists only for individually-held policies but not institutionally-held policies, which is most consistent with a reference point in individual utility. Our study illustrates the potential of behavioral economics frameworks in assisting with identification challenges for classical information economics problems.

Much of corporate managers’ incentive is related to the stock price. Consequently, a firm can design its corporate information environment to tackle its manager’s moral hazard problem. We analyze a model in which the manager needs to exert costly effort to implement a risky, long-term project and the project gives the manager opportunities to make credible disclosure. The optimal disclosure to motivate effort is the manager’s strategic disclosure because it protects the manager from the downside of the project and induces the rational stock market to punish nondisclosure. A more transparent information regime is not always preferred because it may reduce the manager’s discretion on disclosure. We also derive the optimal disclosure when both the effort and the project choice are considered.

It is well known that health insurance coverage increases the demand for health services. However, evidence on the effects of this increased demand on the structure and capacity of the health services market is relatively scarce. We analyze the effects of a reform in the German social health insurance system which caused exogenous variation in coverage for services across different geographic regions. A formal model predicts that the reform led to an immediate decline in demand for services and that it decreased the market capacity in the long run. Our empirical analysis provides strong support for these predictions. We show that the reform was welfare improving under standard assumptions and discuss possible market frictions which could weaken or reverse these conclusions about welfare. Our study informs the ongoing policy debate about the effects of insurance coverage on the societal costs for health care.

We provide evidence on how banks form network connections and endogenous risk-taking in their non-bank counterparty choices in the OTC derivative markets. We use confidential regulatory data from the Capital Assessment and Stress Testing reports that provide counterparty-level data across a wide range of OTC markets for the most systemically important U.S. banks. We show that banks are more likely to either establish or maintain a relationship, and increase their exposures within an existing relationship, with non-bank counterparties that are already heavily connected and exposed to other banks. Banks in such densely-connected networks are more likely to connect with riskier counterparties for their most material exposures. The effects are strongest in the case of (non-bank) financial counterparties. These findings suggest moral hazard behavior in counterparty choices. Finally, we demonstrate that these exposures are strongly linked to systemic risk. Overall, the results suggest a network formation process that amplifies risk propagation through non-bank linkages in opaque financial markets.

Koijen and Yogo (2019, 2020) show that unexplained demand movements are responsible for the majority of asset price changes. This paper helps explain this unexplained demand. Using corporate demand, I provide the first demand-based convenience yield explanation. I show that when managers are exposed to moral hazard, corporate demand will be determined by their idiosyncratic risk. I see in the cross-section that idiosyncratic volatility leads to higher financial asset holdings, higher savings, and has decreased corporate investment by 5% on average annually. In the time series corporate demand predicts 29% of the convenience yield variation. This effect dominates other investor classes such as financial intermediaries. I isolate my demand-based effect from confounders by using exogenous cross-sectional variation from corporate size and industry exposures.

This paper investigates optimal contracts to solve the moral hazard problem with subjective evaluations in the static environment in which the principal privately observes agents’ performances. Despite the limitations of feasible contracts that the principal can credibly offer, we show the irrelevance theorem that the principal is never worse off by subjective evaluations in general static environments. This irrelevance result encompasses a large class of static moral hazard problems, including multidimensional actions, production externalities, and interdependent performance signals.

Private cost information and entrepreneurial moral hazard are serious problems that result from the significant information asymmetry associated with creators and their backers in reward-based crowdfunding. We establish a dynamic game-theoretic model to investigate the effect of moral hazard on the quality and price decisions of a creator (male) when his cost efficiency is unobservable. Backers (female) in the crowdfunding stage directly observe neither the cost efficiency nor the product quality of the creator. They then make pledge decisions based on expectations about the quality after observing the campaign parameter signals (i.e., the reward price and funding goal) and whether the regulation mechanism is implemented with a strong hand (tighter regulations mean that the creators have less moral hazard). We find that compared with the information symmetry case, when the efficiency of creators is not known to backers, an efficient creator always provides a higher level of product quality when moral hazard is present but not always when moral hazard is absent. In addition, we investigate the effect of moral hazard on the creator and consumer surplus when the creator's cost efficiency is unobservable. Interestingly, we show that moral hazard may benefit both the creator and consumers. This explains the puzzling measures of some reward crowdfunding platforms such as Kickstarter and Indiegogo, which take no active role in managing or monitoring the entrepreneurial projects. Finally, we find that reasonably the efficient creator can better signal his efficiency by using two signaling devices, i.e., the reward price and funding goal; in this case, interestingly, the existence of moral hazard may still benefit both the creators and consumers. This confirms the robustness of our main results.

A puzzle of China’s shadow banking system is its stark growth since the 2008 Subprime Crisis, which is in sharp contrast to most of countries. We present a model to explain why the shadow banking activities have been allowed to expand with the full awareness of regulators in China. In the presence of local government intervention, which tends to distort the banks’ portfolio choices towards inefficient low-quality projects, the policy combination of formal banking sector credit tightening and shadow banking sector loosening forces banks to improve credit quality. This is because shadow banking assets are less diversified than commercial bank assets, thereby subject to higher bank run risk, which forces banks to improve the quality of shadow banking assets. Negative shocks to project quality may trigger information production in the shadow banking sector and prevent banks from providing funding to efficient projects, which creates additional welfare losses. This result provides a rationale for China's new regulations on shadow banking sector since 2018 in the background of increasing risks.

This paper examines the optimal provision of incentives for contract designers. A principal hires an agent to draft a contract that is incomplete because the ex-ante specified design might not be appropriate ex-post. The degree of contract incompleteness is endogenously determined by the effort exerted by the agent, who can manipulate the principal's beliefs because his effort may not be observable (moral hazard), and he might be better informed at the outset (adverse selection). We characterize the optimal incentive scheme for the agent and discuss implications for the degree of buyer-seller contract incompleteness and the optimal prices. Without adverse selection, the principal-seller contract is more incomplete and is coupled with a smaller price in a better environment. If the adverse selection problem is severe enough, the principal-seller contract is less incomplete and is coupled with a higher price in a better environment.

We consider multi-agent multi-firm contracting when agents benchmark their wages to a weighted average of their peers, where weights may vary within and across firms. Despite common shocks, compensation benchmarking can undo performance benchmarking, so that wages load positively rather than negatively on peer output. Although contracts appear inefficient, when a single principal commits to a public contract, the optimal contract hedges agents’ relative wage risk without sacrificing efficiency. Moreover, the principal can exploit any asymmetries in peer effects to enhance profits. With multiple principals, or a principal that is unable to commit, a “rat race” emerges in which agents are more productive, but wages increase even more, reducing profits and undermining efficiency. Effort levels are too high rather than too low, and can exceed first best. Wage transparency and disclosure requirements exacerbate these effects. Institutional subscribers to the NBER working paper series, and residents of developing countries may download this paper without additional charge at www.nber.org.

The global financial crisis exposed the need for coherence and transparency in bank liquidity management. The problem of asymmetry of information associated with liquidity was particularly acute during the crisis, leading to both adverse selection and moral hazard problems. The inability to refinance in the market eventually required central banks and states to intervene to purchase assets or provide guarantees at the market level and supply public funds, or nationalize individual banks, to correct the market. The European Central Bank Guide to Internal Liquidity Adequacy places significant focus on management’s oversight and responsibilities in addressing these issues before they materialize, or the existence of contingency plans to manage materialized risks. This guide is simply one component of a complex web of supervisory instruments and tools for banks’ liquidity management. This chapter argues that the crisis prevention narrative is delegated to banks to discharge their obligations in bank supervision so as to minimize the asymmetry of information problems created by their business and improve the way they manage adverse scenarios and the risks to depositors, markets, and supervisory authorities. The first part explains the rationale for a principles-based approach; the second part explores the premise of the principles for liquidity management, namely the responsibility of the bank per se to discharge adequate liquidity management as a form of self-regulation; the third part explains some of the key features of the principles; and the fourth part looks at the features of the principles with specific reference to the crisis prevention measures to improve banks’ responses to liquidity risks. This ‘nuts and bolts’ approach surprisingly lacks reference to bank corporate culture as an important all-encompassing matter when it comes to banks and risk-taking. The final section reflects on these preventive elements and highlights the importance of the ECB combining a risk-based and forward-looking ‘judgement’ based approach to supervision.

We develop a novel framework featuring loss amplification through firm-bank linkages. We use it to study optimal intervention in a lockdown situation that creates cash shortfalls for firms, which must resort to bank lending. Firms’ increased debt reduces their output due to moral hazard. Banks need safe collateral to raise funds. Without intervention, aggregate risk constrains bank lending, amplifying output losses. Optimal government support provides sufficient aggregate risk insurance, and is implemented through transfers to firms and fairly-priced guarantees on banks’ debt. When aggregate risk is not too large, such guarantees can be financed through a procyclical taxation of firms’ profits.

Grimly demonstrated by the COVID-19 pandemic, hospitals serve as the central hub of American health care. Increasingly exercising market power, setting clinical standards, and fostering innovation, hospitals’ influence over health care delivery and access is unmatched. They are the behemoth in the delivery chain, exerting unrivaled control. As such, hospitals have naturally become the locus of the worst of the collision between consumerism and universality, between cost and access—a gloomy setting for citizens who simply cannot afford the health care they need to flourish, or to survive. Indeed, the price of American health care—a cost that is increasingly borne by American patients—is unsustainable. Those costs continue to rise thanks to a pernicious mix of increasingly brittle and ineffective insurance plans, a squeeze on public funding, and a lack of price sensitivity among the providers of American health care. Patients are suffering. And hospitals aren’t getting paid. In a predictable but catastrophic turn, hospitals are suing their former patients for unpaid medical bills. Litigation has replaced systematic financing. The operating room has been swapped for the courtroom. And adversarial proceedings now follow the Hippocratic Oath. Tracking the phenomenon of these lawsuits, this article lays out the harms that result to the American health care system. When hospitals sue patients, they harm public health and destroy patient trust. And they shatter widely-held beliefs, highlighting the inadequacy of policy goals and the inequity of health finance rules. Further, once and for all, they expose the failure of the consumer-based paradigm of American health care, spotlighting the inapplicability of moral hazard, and demonstrating the means by which individuals with private insurance and high deductibles—a rapidly growing population in the United States—are inadequately protected against the very actors that undertake to protect their health and wellbeing. This article makes the moral, legal, and policy-based argument that hospital lawsuits against former patients must be brought to an end. American patients simply cannot afford it.

Relying on the merit goods concept developed by Richard A. Musgrave, this paper introduces the notion of quasi-merit good. The criteria of eligibility for merit goods are vague. Quasi-merit good constitutes a special case where government protection and sponsorship are obtained via public choice influenced by special interests or a misconception. I claim that private bank deposits are a quasi-merit good meant to satisfy the public want of bank stability and uninterrupted supply of household savings into the financial system. Bank stakeholders join with other social and political groups to demand government intervention. It becomes institutionalized in the shape of a government-backed deposit protection scheme that ‘nudges’ depositors to act in a desirable way. Government assumes an implicit liability under deposit guarantee, but may be required to inject public funds to keep the scheme running. Deposit protection has distributional effects: welfare is redistributed in favor of special interests. Its premature enactment generates massive moral hazard among depositors and bankers.