Credit and Collateral

Abstract

Moral hazard is a widespread source of inefficiency in economics. In financial contracting, both classical forms of moral hazard exist, each giving rise to specific incentive issues.¹ In a situation of hidden action, the agent takes an action that is not observed by the principal. For example, the borrower might try to influence the return distribution of his project to increase his expected payoff at the expense of the lender. This is the so-called risk-shifting or asset substitution problem, which was first laid out by Jensen and Meckling (1976). In contrast, in a situation of hidden information, the agent privately observes the true state of the world prior to choosing an observable action. In the context of financial contracting, the borrower typically is the only person that can observe project returns at no cost. To the extent that his promised payment depends positively on realized project return, he might have an incentive to understate project return in order to reduce his payment to the lender. This form of information asymmetry gives rise to the so-called observability problem, which was addressed in the costly state verification literature in the wave of Townsend’s (1979) pathbreaking paper. The main conclusion of this literature is that costly state verification by the principal (lender) makes complete risk-sharing suboptimal.