Abstract
In this paper, we discuss optimal contract drafting between a lender with deficient monitoring capabilities and an agency-ridden borrower with insufficient budget to finance an investable project. The theoretical implications are as follows: First, the first best solution (FBS) is achievable under no hidden action. However, the borrower’s action is hardly observable in practice. Second, with unobservable managerial decisions the borrower exerts sub-optimal effort (moral hazard), and the probability of default increases. Lastly, with a penalizing discretion entitled to the bank on a long-term contract, the financial intermediary will be able to control the firm’s managerial action effectively such that the solution is equivalent to the FBS attained under no hidden action. Empirical implications are followed.
| Original language | English |
|---|---|
| Pages (from-to) | 115-122 |
| Number of pages | 8 |
| Journal | Journal of Applied Business Research |
| Volume | 33 |
| Issue number | 1 |
| DOIs | |
| State | Published - 2017 |
Bibliographical note
Funding Information:We thank Dean Manna (Editor), anonymous referees, Dimitri Andriosopoulos, Wolfgang Bessler, Swarnava Biswas, Jaejune Han, Robert Y. Lin, and participants at Financial Engineering and Banking Society 2013 (Paris, France), Multinational Finance Society 2014 (Prague, Czech Republic), and Asia-Pacific Conference 2015 (Da Nang, Vietnam). We are also grateful to Hyeik Kim, Ye Jun Kim, Young Bin Han, Poramapa Poonpakdee, and Mookyoung Son for their excellent research assistance. This work was supported by the Ministry of Education of the Republic of Korea and the National Research Foundation of Korea (NRF-2016S1A5B5A07915509). Standard disclaimer rules apply and all errors are our own.
Publisher Copyright:
© by author(s).
Keywords
- Bank loan
- First best solution
- Moral hazard
- Optimal contract