Anna Maria Cristina Menichini

Liars and Inspectors: Optimal Financial Contracts When Monitoring is Non-Observable

Within a costly state verification setting, we derive the optimal financial contract between an entrepreneur, a (potentially financing) supervisor and a pure investor when there is non-verifiable and non-contractible monitoring and limited liability. We show that diversion of cash flows to the entrepreneur arises as optimal behaviour and that to get the best reporting and monitoring incentives it is crucial to separate the financing from the monitoring role. In particular, higher efficiency can be achieved by ensuring that the entrepreneur and the supervisor do not collect any cash flows in low states. These should be paid to a third party instead, the pure investor, who in exchange provides funding. However, whether the pure investor entirely finances the project (and the supervisor purely acts as a monitor) or only provides partial finance (with the supervisor cofinancing) is immaterial, as the optimal financing of the project can justify a range of alternative financial structures.

The Role of Bargaining Initiative under No Commitment to Audit

This paper addresses the issue of the optimal contract design under costly state verification and no commitment to auditing when the contract offer comes from the uninformed party. Contrary to similar frameworks and to cases where the informed party retains the bargaining power, we find that the optimal contract is characterised neither by truth telling nor by mixed strategy equilibria. Depending on endogenous revenues and observation cost, a pooling equilibrium with either deterministic or random auditing occurs. Copyright 2001 by Scottish Economic Society.

Contracts with Wishful Thinkers

Managers with anticipatory emotions have higher current utility if they are optimistic about the future. We study an employment contract between an (endogenously) optimistic manager and realistic investors. The manager faces a trade-off between ensuring that the chosen levels of effort reflect accurate news and savoring emotionally beneficial good news. We show that optimism may exacerbate incentive problems. Specifically, investors and manager agree over the optimal news recall when the managers weight on anticipatory utility is low. For intermediate values, there is a conflict of interest and investors bear an extra-cost to have the manager recalling bad news. For high weights on anticipatory utility, investors become indifferent between inducing signal recollection or not, and a pooling equilibrium obtains, reminiscent of adverse selection models. We then extend the analysis to the case in which the parameter capturing anticipatory utility is the managers private information. Last, we derive interesting testable predictions on the relationship between personality traits, managerial compensation and hiring policies.In a setting with a wishful thinking agent and a realistic principal, the paper studies how incentive contracts should be designed to control for both moral hazard and self-deception. The properties of the contract that reconciles the agent with reality depend on the weight the agent attaches to anticipatory utility. When this is small, principal and agent agree on full recollection. For intermediate values the principal bears an extra cost to make the agent recall bad news. For large weights the principal renounces inducing signal recollection. We extend the analysis to the case in which the parameter of anticipatory utility is private information. The distinction between the two settings assumes practical relevance if preferences can be related to personality characteristics as in this case the parameter of anticipatory utility could be learned through psychological testing.

Third Parties, Information Disclosure and Monitoring Incentives

Within an incomplete contract setting, the paper analyses the role of third parties in ameliorating incentive problems arising in the context of financial contracts with costly verification and lenders bargaining power. Contrary to the findings of the bilateral lender–borrower relationship, characterised by no information revelation and possibly a breakdown of the market, it is shown that, in the presence of third parties, an optimal contract exists featuring partial information revelation and random monitoring. The importance of third parties is therefore not limited to improving efficiency, as it is when the contract offer comes from the informed party, but to ensure project realisation, and thus to ensure that the surplus that can arise from the project does not get lost.

Firms’ trade-financing decisions during crises

The bursting of the subprime mortgage market in the United States in 2008 and the ensuing global financial crisis were associated with a rapid decline in global trade. The extent of the trade collapse was unprecedented: trade flows fell at a faster rate than had been observed even in the early years of the great depression. G-20 leaders held their first crisis-related summit in November 2008. The goal was to understand the root causes of the global crisis and to reach consensus on actions to address its immediate effects. In the case of trade, a key question concerned the extent to which a drying up of trade finance caused the observed decline in trade flows. This book brings together a range of projects and studies undertaken by development institutions, export credit agencies, private bankers, and academics to shed light on the role of trade finance in the 2008-09 great trade collapse. It provides policy makers, analysts, and other interested parties with analyses and assessments of the role of governments and institutions in restoring trade finance markets. A deeper understanding of the complexity of trade finance remains critical as the world economy recovers and the supply of trade finance improves. The international community continues to know too little about the fragility of low income economies in response to trade finance developments and shocks, as well as about the ability and conditions of access to trade finance by small and medium enterprises and small banks in developing countries. Similarly, there is uncertainty regarding the impact on trade finance of recent changes in the third Basel regulatory framework.Firms procure funds not only from specialized financial intermediaries, but also from suppliers, generally by delaying payments. The empirical evidence on trade credit raises questions that are hard to reconcile with existing theories: • What justifies the widespread use of trade credit by financially unconstrained firms that have access to seemingly cheaper alternative sources? • Why is the reliance on trade credit not always increasing in the degree of credit rationing? • Does input lending affect the borrower’s choice of inputs? • Does the degree of creditor protection affect financing and input choices? This chapter addresses these questions in a unified framework.