Moral Hazard

To analyze the implications of bargaining power, some authors have com- pared only the two extreme situations where either the Principal or the Agent can make ‘take it or leave it’ offers (e.g. Mookherjee and Ray 2002). By contrast, Pitchford (1998) considers also intermediate allocations of bar- gaining power, which he represents by varying the agent’s reservation utility in a standard P-A model. A different approach is adopted by Balkenborg (2001), who uses the Nash bargaining solution to analyze a similar moral hazard problem. Alternatively, one could analyze bargaining power in an alternating offer game with model hazard. None of the cited papers dis- cusses the relationship between these different options, and the reasons for adopting their particular approach. The present paper aims to fill this gap. For the case of risk-neutral parties and a financially constrained agent we show that the same set of contracts arises from varying the agent’s reser- vation utility in a P-A model, the discount factors in an alternating offer game `a la Rubinstein (1982), or the bargaining power coefficient in a Nash bargaining game. Since our moral hazard model gives rise to a concave Pareto frontier, this equivalence does not come as a surprise. However, due to moral hazard and the liability limit the relationship between the differ- ent ways to represent bargaining power – through the reservation utility, discount factors and bargaining power coefficients – is not one-to-one as in a ‘standard’ bargaining game. In particular, variations in the reservation utility or in discount factors may have no effect on bargaining outcomes, while changes in the bargaining power coefficient always do so.

forms. Is there some good reason why some homeowners would want one of these forms and other homeowners want another? This question is analogous to the question, in finance, why different people want different portfolios of options and other derivatives. The answer is probably sufficiently complex that there is no simple answer. The answer has probably to do with differing opinions about future price movements, differing information sets, differing asset positions and income flows, differing worries and concerns, differing ways of framing the issues. Our concern here, however, is not with reasons for these different contracts, but with the moral hazard associated with them. Fortunately, as we shall see now, the moral hazards created by all these different home equity conversion contracts have a certain family resemblance.

implemented with standard …nancial instruments and showed the convergence of the discrete-time model to the continuous-time version of DeMarzo and San- nikov’s (2006) model. Sannikov (2008) used a very elegant technique based on the Martingale Representation Theorem to solve a continuous-time moral hazard problem that allowed him to obtain a very clean characterization of the optimal contract. The optimal balance between immediate compensation and the contin- uation value was shown also in Biais, Mariotti, Rochet, and Villeneuve (2010), where the principal can a¤ect the agent’s continuation value through a change in the …rm’s size. In a recent paper Edmans, Gabaix, Sadzik, and Sannikov (2010) analyzed a dynamic moral hazard problem with a risk-averse agent and a risk-neutral principal. In their paper, too, compensation for performance in any given period is spread over future periods. The optimality of the spread follows from the optimal risk-sharing perspective, while in our paper the spread is used to reduce the cost of screening the types of the agent.

To gain intuition, it may be useful to discuss the nature of the e¢ cient contract in this setting. Because of our CARA assumption, premiums are a transfer which do not a¤ect total surplus. Therefore, the e¢ cient contract can be characterized by the e¢ cient coverage function c ( ) that maximizes total surplus (as given by equation (16)) over the set of possible coverage functions. Such optimal contracts would trade o¤ two o¤setting forces. On one hand, an individual is risk averse while the provider is risk natural, so optimal risk sharing implies full coverage, under which the individual is not exposed to risk. On the other hand, the presence of moral hazard makes an insured individual’s privately optimal utilization choice socially ine¢ cient; any positive insurance coverage makes the individual face a healthcare price which is lower than the social cost of healthcare, leading to excessive utilization. E¢ cient contracts will therefore resolve this tradeo¤ by some form of partial coverage (Arrow, 1971; Holmstrom, 1979). For example, it is easy to see that no insurance (c (m) = m) is e¢ cient if individuals are risk neutral or face no risk (F ( ) is degenerate), and that full insurance (c (m) = 0) is e¢ cient when moral hazard is not present (! = 0 ). In all other · situations, the e¢ cient contract is some form of partial insurance.

Bank crises, by interrupting liquidity provision, have been viewed as resulting in welfare losses. In a model of banking with moral hazard, we show that second best bank contracts that improve on autarky ex ante require costly crises to occur with positive probability at the interim stage. When bank payo¤s are partially appropriable, either directly via imposition of …nes or indirectly by the use of bank equity as a collateral, we argue that an appropriately designed ex-ante regime of policy intervention involving conditional monitoring can prevent bank crises.

Recent empirical research, based on cross-country-regression analysis, has identi- fied a negative relation between inequality and growth. Prominent examples include Persson and Tabellini (1994) and Aghion et al. (1999). In response to this finding, models have been constructed which predict lower growth rates as inequality be- comes more severe. For surveys of the recent theoretical literature, see Barro (2000), Aghion et al. (1999) and Benabou (1996). There exists a variety of ap- proaches which encompass political turmoils as well as voting behavior as possible transmission channels. Another strand of the literature examines the role of credit- market imperfections due to moral hazard in the inequality-growth context (e.g. Aghion and Bolton, 1997; Piketty, 1997). These contributions build on an incentive argument whereby inequality worsens entrepreneurial incentives which in turn depresses the economys growth rate as emphasized by Aghion et al. (1999). 1 Entre- preneurial investment projects in these models are very specific in that project returns follow a binomial distribution.

We use an exogenous change in the way Austrian firms are compensated for their workers’ sickness absences in order to shed light on these firms’ moral hazard problems. The Austrian social insurance system provides an excel- lent setting for the analysis of moral hazard and sickness absences because Austrian legislation guarantees each regular employee continued wage pay- ments for at least six weeks, to be paid by the employer. Barmby, Ercolani and Treble (2002) argue that to understand fully the impact of regulations on absence rates, it is necessary to gather data that enable the analysis of a regime shift within a single jurisdiction.

competitive equilibrium where contingent securities are traded at actuarially unfair prices can exist, and is characterized by first-order conditions, when processing unit insurance contracts is costly. Transaction costs do not by themselves imply inefficiency, and the inefficiency arising from moral hazard can be addressed by linear taxation of anonymous insurance transactions or by public transfer schemes that use a transaction technology different from the one that produces private insurance contracts. On such issues, our contribution is related to those of Gottardi and Pavoni (2011) and of papers where first-order conditions characterize interactions between exclusive insurance and public policies (Golosov and Tsyvinsky, 2007; Chetty and Saez, 2010). 2

The results for the sample of both listed and unlisted banks suggest that U.S. banks decrease payout ratios to a greater extent than EU banks when they are close to the minimum capital requirement. This finding is consistent with the view that PCA are useful in decreasing moral hazard, and supports the recent changes in the Basel Accord (Basel III) that impose progressive dividend restrictions on banks that are undercapitalised (Brunnermeier et al., 2009; Caruana, 2010). In light of the results on the impact of charter value on payout ratios, dividend restrictions would be particularly useful in periods of high competition, when charter values are low (Keeley, 1990), or during periods of weak economic growth.

Such selection on moral hazard has implications for the standard analysis of both selection and moral hazard. For example, a standard – and ubiquitous – approach to mitigating selection in insurance markets is risk adjustment, i.e. pricing on observable characteristics that predict one’s insurance claims. However, the potential for selection on moral hazard suggests that monitoring techniques that are usually thought of as reducing moral hazard –such as cost sharing that varies across categories of claims with di¤erential scope for moral hazard – may also have important bene…ts in combatting adverse selection. In contrast, a standard approach to mitigating moral hazard is to o¤er plans with higher consumer cost sharing. But if individuals’anticipated behavioral response to coverage a¤ects their propensity to select such plans, the magnitude of the behavioral response could be much lower (or much higher) from what would be achieved if plan choices were unrelated to the behavioral response. As we discuss in more detail below, not only the existence of selection on moral hazard but also the sign of any relationship between anticipated behavioral response and demand for higher coverage is ex ante ambiguous. Ultimately, these are empirical questions. To our knowledge, however, there is no empirical work on selection on moral hazard in insurance markets.

The two equations of the model allow for separation and estimation of the effects of real and nominal moral hazard as the benefit level increases. Moral hazard is based on the percentage change in indemnity payments (equation 1) and on the percentage change medical payments (equation 2). The percentage change is calculated by taking the derivative of the logarithm of each side of both equations 1 and 2 with respect to the logarithm of price-adjusted benefit level. The differentiation of the logarithm of equation 1 yields the sum of the measures of real and nominal moral hazard plus a value of one. The value of one results because as the benefit level increases by one percent, the expected indemnity payments will increase by one percent (absent any moral hazard), and Butler and Worrall refer to this value as the "actuarial effect." However, the result from differentiating the logarithm of both sides of equation 2 represents a measure of only real moral hazard.

Richardson’s insights into other forms of moral hazard at work are difficult to quantify empirically. However, examiners’ comments in the examination re- ports we used in our paper offer some support for his general claim. Each report concludes with a section titled “Management and General Condition.” In it, ex- aminers respond to the following questions: “Is the management safe?” “Com- petent?” Looking at a sample of 35 reports concerning banks that failed in the subsequent reporting period, we find that 18 of the banks were judged unsafe and incompetently managed. (Additional examiners’ comments are reproduced in Table 3 below.)

Abstract. The paper argues that policymakers bail out banks with financial problems to avoid the costs of financial repression. After financial liberalization and when risk is verifiable, in some circumstances policymakers can commit to policies that discipline banks ex-ante and ex-post, by providing bailout to conservative banks and threatening the takeover of risky banks. When these policies are time consistent, regulatory policies to deal with moral hazard ex-ante, like for example prudential regulation, become redundant and policymakers refrain from implementing them.

One of the key questions after the sovereign defaults in emerging markets of the 1990’s was to what extent the availability of IMF bailouts could result in moral hazard by investors and borrowing countries. Rogoff (2002) has casted doubt on the belief that moral hazard should be a big concern to taxpayers who finance IMF bailouts, noting that “IMF loans have had a stubborn habit of being repaid in full”. Recently, the European debt crisis has renewed interest in the questions involving the role and the inintended consequences of bailouts.

In a model of moral hazard and perfect public monitoring, Klein and Leffler demonstrate that when quality is unobserved before purchase the equilibrium price must be above average cost o[r]

In the traditional model of Bertrand price competition among symmetric firms, there is no restriction on the number of firms that are active in equilibrium. A symmetric equilibrium exists with the different firms sharing the market. I show that this does not hold if we preserve the symmetry between firms but introduce moral hazard with a customer-sensitive probability of exposure; competition necessarily results in a natural monopoly with only one active firm. Sequential price announcements and early adoption are some equilibrium selection mechanisms that help to pin down the identity of the natural monopolist. If we modify the standard Bertrand assumptions to introduce decreasing returns to scale, a natural oligopoly will emerge instead of a natural monopoly. The insights of the basic model are robust to many extensions.

In the current crisis, banking regulations combined with the poor management and supervision, in part, have been responsible for the bank’s improper leverages, lending and securitization. A bank failure could easily turn into a crisis when the financial institution is overly exposed to credit risks and when the government is least equipped to deal with those risks. While regulatory arbitrage and incomplete risk transfers increase the risk in the banking system, pricing of deposit insurance that subsidizes bank's improper investment decisions may also exacerbate risk taking. 3 In this paper, we study the effect of the well-designed deposit insurance to manage bank’s moral hazard induced by unsophisticated regulations prior to a crisis.

share contract and the fixed rent contract can act as a screening device which is used to distinguish the tenants with different skills or abilities. Allen (1982) stresses that when the quality of land and the abil- ity of tenants are both unobservable, the use of the associated contracts may be desirable. Eswaran and Kotwal (1985) develop a double-sided moral hazard model in which the landlord and the tenant are bet- ter in providing different unmarked factor inputs. Sharecropping as a partnership can better deal with this kind of moral hazard problem. Agrawal (1999) further builds a generalized model based on Eswaran and Kotwal (1985), and proves that the optimal con- tract maximizes output net of the risk-bearing and agency costs. Laffont and Matoussi (1995) highlight the dual role of moral hazard in the course of provid- ing the effort and financial constraints. The tenant’s financial constraints may make the fixed rent con- tract impossible, while sharecropping can flexibly adjust the share that the tenant retains. Ghatak and Pandey (2000) consider a case in which there is a joint moral hazard on the part of the tenant. Under the fixed rent contract, the tenant tends to choose too risky cultivation techniques in the presence of limited liability. The share contract can emerge as a solution to balance the tenant’s effort supply and risk choice. Dubois (2002) considers the role of land fertility in the determination of the optimal contract. The contractual choice depends on the trade-off between the possibility of the land overuse and its fertility. Basu (1992) argues that when there is a limited liability clause, the landlord’s interest can be harmed less under the share contract than under the fixed rent contract. Sengupta (1997) re-examines

This paper studies a moral hazard problem in repeated procurement of services by a model with two periods and two homogeneous and risk-neutral agents. In the first period, there is an incumbent that provides a service. In the second period, the incumbent is challenged by an opponent for providing a future service. The designer wants to maximize service effort and chooses how to bias the contest to mitigate the moral hazard problem. In the contest, past service effort is considered as a bias and a CES function relates the incumbent’s past service effort with his current contest effort. On the one hand, when contest effort is wasteful, it is shown that the designer’s optimal choice is to consider service 2 effort as the only relevant effort in the contest stage when the provider of service 1 did not shirk. On the other hand, when contest effort is valuable for the designer, the designer’s optimal choice is to consider service and contest efforts equally important and more (less) substitutes when effort cost is low (high). The results of this paper provide some valuable insights into how to improve procedures commonly applied in repeated provision of services. Past performance should be taken into account in the design of future contests to mitigate moral hazard problems although it can disincentive competition in future contests. Therefore, it becomes particularly important to determine the optimal degree to which contests should be biased towards past performance when the designer values contest effort. It turns out that when effort cost increases for the agents, the designer should increase the incumbent’s advantage for former high performance (i.e., allow for a lower degree of substitutability in the CSF) to mitigate the moral hazard problem at the expense of reducing future competition.

An IMF loan differs from an insurance contract in several aspects. Insurance contracts render permanent transfer of funds from the insurer to the insured on realization of the risk. In contrast, IMF financial support is not a permanent transfer and comes as a loan to be repaid with interest. Nevertheless, even if the transfer is temporary, the interest rate of IMF subsidized loans is much lower than the rate at which a country could borrow from private capital markets during a crisis. Hence, the “insured benefit” from the IMF lending might be sufficiently substantial to entail “debtor moral hazard”. From the perspective of investors, it is clear that IMF’s limited intervention does not provide a “complete guarantee” of the debt service. Nevertheless, the increased frequency and size of IMF financial support in recent years seem to indicate there exists a significant distortion of incentives to investors, which can cause “creditor moral hazard”.