Dynamic Financial Contracting

Taking stock of Modigliani and Miller's (1958) celebrated result that, with perfect capital markets, financial structure is irrelevant, corporate finance has studied how various market imperfections make different capital structures more or less attractive. In line with the seminal insights of Jensen and Meckling (1976), a large fraction of the literature has focused on the conflicts of interest arising between investors and managers. When the latter have more information about their firms and their own actions than outside investors, an agency problem arises. Managers can take actions that are in the interest of investors, such as working hard to improve cash flows. Alternatively, they can choose to enjoy private benefits, at the expense of investors. For example, when it comes to hiring staff, managers may prefer friendly but inefficient family members rather than more competent but potentially threatening outsiders. Or, they could engage in loss-making empire building and prestige-driven activities. In the financial sector, managersmight rely on ratings and brokers' advice rather than conducting time and resource-consuming checks on the quality of assets they consider for their portfolios.When such actions are unobservable by investors and when managers have limited liability, a moral-hazard problem arises. In this context, the first generation of corporate-finance models analyzed the equilibrium interaction between managers and investors for a given type of financial contract, such as debt or equity. As noted by Harris and Raviv (1992): A much deeper question, however, is what determines the specific form of the contract (security) under which investors supply funds to the firm…. Therefore, financial contract design must resolve the problem of allocating the cash flows generated to investors.