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Contractual externalities and systemic risk

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  • Ozdenoren, Emre
  • Yuan, Kathy

Abstract

We study effort and risk-taking behaviour in an economy with a continuum of principal–agent pairs where each agent exerts costly hidden effort. Principals write contracts based on both absolute and relative performance evaluations (APE and RPE, respectively) to make individually optimal risk–return trade-offs but do not take into account their impact on endogenously determined aggregate variables. This results in contractual externalities when these aggregate variables are used as benchmarks in contracts. Contractual externalities have welfare changing effects when principals put too much weight on APE or RPE due to information frictions. Relative to the second best, if the expected productivity is high, risk-averse principals over-incentivize their own agents, triggering a rat race in effort exertion, resulting in over-investment in effort and excessive exposure to industry risks. The opposite occurs when the expected productivity is low, inducing pro-cyclical investment and risk-taking behaviours.

Suggested Citation

  • Ozdenoren, Emre & Yuan, Kathy, 2017. "Contractual externalities and systemic risk," LSE Research Online Documents on Economics 75998, London School of Economics and Political Science, LSE Library.
  • Handle: RePEc:ehl:lserod:75998
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    Cited by:

    1. André F. Silva, 2019. "Strategic Liquidity Mismatch and Financial Sector Stability," Finance and Economics Discussion Series 2019-082, Board of Governors of the Federal Reserve System (U.S.).
    2. Qi Liu & Bo Sun, 2016. "Relative Wealth Concerns, Executive Compensation, and Systemic Risk-Taking," International Finance Discussion Papers 1164, Board of Governors of the Federal Reserve System (U.S.).
    3. Emre Ozdenoren & Kathy Yuan, 2017. "Contractual Externalities and Systemic Risk," Review of Economic Studies, Oxford University Press, vol. 84(4), pages 1789-1817.

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    More about this item

    Keywords

    Contractual externalities; relative and absolute performance contracts; procyclicaleffort exertion and risk taking; many principal-agent pairs;
    All these keywords.

    JEL classification:

    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G30 - Financial Economics - - Corporate Finance and Governance - - - General

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