2.2. Debt contract with liquidation (DCL) as a means of alleviation of moral hazard. The inefficiency of DCL

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From the course by Moscow Institute of Physics and Technology

Capital Markets and Financial Institutions – How to Survive Them

4 ratings

Moscow Institute of Physics and Technology

Capital Markets and Financial Institutions – How to Survive Them

4 ratings

Course 1 of 5 in the Specialization Understanding Modern Finance

Capital markets and financial institutions are all around us. This is an enormous industry in which powerful players oftentimes challenge investors and the public at large and expose them to significant risks. This Course provides for the deep understanding of the core ideas, concepts, and mechanisms of the modern capital market in a learner-friendly way. We will analyze the market’s most fundamental problems, realize the intrinsic interests of the market participants, reveal the true meaning of certain financial terms, and uncover credible signals of the likely behavior of economic agents – all that with little math and a lot of fun. The learners will be much better positioned with respect to the financial environment. They will see through the financial news, reveal the risks of the financiers’ wishful thinking promises, and protect themselves against dangerous adventures. The learners will get the opportunity to use the obtained knowledge, skills, and understanding for the successful professional career in the financial and other business areas, as well as in their day-to-day life.

From the lesson

ALLEVIATION OF MORAL HAZARD – DEBT AND EQUITY CONTRACTS. BANKS (1) – DIVERSIFICATION AND MONITORING

In Week 2 we will consider certain ways of overcoming problems caused by private information and evaluate them. We will know why some methods work while others don’t, and why. You will learn the core differences between equity and debt financing, study debts contracts with liquidation and see the core inefficiency of that kind of a debt contract. Based on a simple model you will study diversification and delegated monitoring and see how they contribute to the efficiency of lending. We will find out how a bank emerges as a key financial intermediary responsible for asset monitoring. You will be able to see why the bank can make money and to calculate its profit in different cases. At the end of Week 2 we will pose a fundamental question: How does the bank attract depositors?

2.1. Infeasibility of equity financing in the presence of unobservability7:11

2.2. Debt contract with liquidation (DCL) as a means of alleviation of moral hazard. The inefficiency of DCL6:41

2.3. Monitoring as a universal and efficient way of overcoming unobservability5:20

2.4. Multiple lenders (1) – the model8:19

2.5. Multiple lenders (2) – bank contracts5:15

2.6. Delegated monitoring (1) – the interaction of the parties and bank’s profit12:09

2.7. Delegated monitoring (2) – banks’ vulnerability to runs5:21

Meet the Instructors

Konstantin Kontor
Director and Professor of Finance and Strategy
American Institute of Business and Economics (AIBEc)

Let's proceed, because we see that a great project cannot get equity financing.

What can we do?

Well, we have to go back to borrowing, why?

Because in this set up where

the investor does not observe what state of the world occurred in reality.

The conditions of the contract should be based on something what I,

the project manager, the project owner, say or claim.

So the conditions of investment should be based on my words,

so somehow investors should make sure that it is not to my benefit to lie to them.

Let's see how can it arranged.

We are back to the same situation, so we have now high and

low state, same probabilities, same cash flows.

And now, we are back to the borrowing contract.

So, 6 million is given by the bank,

and F is what is the required back.

How could we calculate this F?

So the contract looks like this,

I give you $6 million, I say you will pay me back, F.

If you fail to make this payment of F, then no one gets anything.

Let's say your project, your company goes bankrupt, and

all the money goes to the lawyers.

Now, let's see what F is.

Well first of all, we can see clearly that F should be greater or

equal than 6, otherwise I won't recover my money.

Or N should be less than or equal than 15 or

otherwise, even in this great project I won't be able to make the payment.

Now, let's see what's expected cash flow to the bank.

That's what we did in the previous week, in the final episodes.

Well, with probability of %80, the bank gets back its F

because you see that F is less or equal than 15 so we are fine.

Then we say, well, seems like with probability of 20, we could have got 5.

And then if that would be equal to my expected cash flow of 6 because

I'm a responsible bank and I have choose break even from this.

Solving this equation, we could have concluded that F should be = to 6.25.

Now, however, this is a wrong thing and I will explain why.

The thing is that this 5,

Cannot be recovered, because I say that if you fail to make a payment of F,

which happens in the lower case, you case see from this condition.

Then, you get no money, everything goes to the lawyer.

So here, we actually have 0.

And the equation transforms and

it goes to 0.80 times F + 0.20 times

0 is = to 6 to where F is = to 7.5.

So this is the face value below under the death contract of liquidation.

So we can see that we've been able to overcome the problem

of non-feasibility of equity investment.

We can indeed finance this nice project with that kind of a loan.

Now this loan is not so bad.

We can see what happens to the expected cash flow to the borrower

in this case because basically we can see that this is the bank.

Well the bank we see that the counter goes like this.

I give 6 million and I get back 7.5.

Now that might expected cash flow,

is exactly 6, so I just break even.

Let's take a look at the borrower.

Well, expected cash flow to the borrower.

I will put just expected cash flow without B otherwise

you can get mixed up with the bank is.

We have probability of 0.8, I get back how much.

I get back 15 is my cash flow- 7.5, this is what I paid to the bank, right,

+ the probability at the point where I get nothing, so that's also $6 million.

Well this is kind of nice.

Remember, before when we said with the equity investment, I had 7 but

this time, it's a little bit less because I have to pay some interest to the bank.

And, I lose something here, all right.

Now, so we can see that the good news is this, that contract with liquidation,

it does solve a problem, Of financing.

And that's great.

However, you can see that this threat of everything goes to

the lawyers in the case that indeed we arrived at the low state and

we have just $5 million we will lose that, how much do we lose?

We lose an expected probability 120 times 5 $1 million.

So this is inefficiency.

So it is inefficient.

So we did solve the problem, but we arrived at inefficiency.

Now the question goes, can we do anything to overcome this inefficiency,

to save this expected $1 million?

Well, clearly we can.

And that is what we will do in the next episode.

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