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Incentive Effects of Benevolent Intervention - The case of government loan guarantees

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  • Paul K. Chaney

    (Vanderbilt University)

  • Anjan V. Thakor

    (Washington University in St. Louis)

Abstract

There has been a substantial recent growth in government loan guarantees to ailing firms in the United States. This paper investigates the potential incentive effects of this practice. Using the simplest available two-period model, it is shown that when firms know that loan guarantees may be forthcoming, they may be induced to adopt riskier investments and take on more leverage. These perverse incentive effects imply that the actual loan-guarantees-related contingent liability of the government could be much larger than suspected. Our policy recommendation is that the government either abandon the practice altogether or set up a federal agency that sells loan guarantees to all firms at prices that depend on the riskiness of the firm's assets and its leverage.

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File URL: http://128.118.178.162/eps/fin/papers/0411/0411047.pdf
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Bibliographic Info

Paper provided by EconWPA in its series Finance with number 0411047.

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Length: 21 pages
Date of creation: 30 Nov 2004
Date of revision:
Handle: RePEc:wpa:wuwpfi:0411047

Note: Type of Document - pdf; pages: 21
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Web page: http://128.118.178.162

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  1. Myers, Stewart C., 1977. "Determinants of corporate borrowing," Journal of Financial Economics, Elsevier, vol. 5(2), pages 147-175, November.
  2. Steven Shavell, 1979. "Risk Sharing and Incentives in the Principal and Agent Relationship," Bell Journal of Economics, The RAND Corporation, vol. 10(1), pages 55-73, Spring.
  3. Harris, Milton & Raviv, Artur, 1979. "Optimal incentive contracts with imperfect information," Journal of Economic Theory, Elsevier, vol. 20(2), pages 231-259, April.
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  5. Bengt Holmstrom, 1982. "Moral Hazard in Teams," Bell Journal of Economics, The RAND Corporation, vol. 13(2), pages 324-340, Autumn.
  6. Heinkel, Robert, 1982. " A Theory of Capital Structure Relevance under Imperfect Information," Journal of Finance, American Finance Association, vol. 37(5), pages 1141-50, December.
  7. Kraus, Alan & Litzenberger, Robert H, 1973. "A State-Preference Model of Optimal Financial Leverage," Journal of Finance, American Finance Association, vol. 28(4), pages 911-22, September.
  8. Ross, Stephen A, 1973. "The Economic Theory of Agency: The Principal's Problem," American Economic Review, American Economic Association, vol. 63(2), pages 134-39, May.
  9. Rubinstein, Mark E., 1973. "Corporate Financial Policy in Segmented Securities Markets," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 8(05), pages 749-761, December.
  10. Bengt Holmstrom, 1979. "Moral Hazard and Observability," Bell Journal of Economics, The RAND Corporation, vol. 10(1), pages 74-91, Spring.
  11. Jensen, Michael C. & Meckling, William H., 1976. "Theory of the firm: Managerial behavior, agency costs and ownership structure," Journal of Financial Economics, Elsevier, vol. 3(4), pages 305-360, October.
  12. Joseph E. Stiglitz, 1972. "Some Aspects of the Pure Theory of Corporate Finance: Bankruptcies and Take-Overs," Bell Journal of Economics, The RAND Corporation, vol. 3(2), pages 458-482, Autumn.
  13. Sosin, Howard B, 1980. " On the Valuation of Federal Loan Guarantees to Corporations," Journal of Finance, American Finance Association, vol. 35(5), pages 1209-21, December.
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Cited by:
  1. James D. Hamilton, 2013. "Off-Balance-Sheet Federal Liabilities," NBER Working Papers 19253, National Bureau of Economic Research, Inc.
  2. BOADWAY, Robin & MARCEAU, Nicolas & MARCHAND, Maurice, 1994. "Time-Consistent Subsidies to Unlucky Firms," Cahiers de recherche 9413, Université Laval - Département d'économique.
  3. Shah, Salman & Thakor, Anjan V., 1987. "Optimal capital structure and project financing," Journal of Economic Theory, Elsevier, vol. 42(2), pages 209-243, August.
  4. Duchin, Ran & Sosyura, Denis, 2014. "Safer ratios, riskier portfolios: Banks׳ response to government aid," Journal of Financial Economics, Elsevier, vol. 113(1), pages 1-28.
  5. Iichiro Uesugi & Koji Sakai & Guy M. Yamashiro, 2006. "Effectiveness of Credit Guarantees in the Japanese Loan Market," Discussion papers 06004, Research Institute of Economy, Trade and Industry (RIETI).
  6. William G. Gale, 1987. "The Allocational and Welfare Effects of Federal Credit Programs: A Summary," UCLA Economics Working Papers 460, UCLA Department of Economics.

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