Do Bank Loans Curb Corporate Moral Hazard?

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.