Early Warning Signals and Risk-Shifting Incentives
41 Pages Posted: 17 Aug 2019 Last revised: 18 Mar 2021
Date Written: March 5, 2021
Early warning signals in debt contracts allow lenders to take interventive actions such as liquidating unprofitable projects. We study the optimal design of early warning systems when managers can engage in value destroying risk-shifting behavior once the debt contract is in place. We find that the optimal information system leads to either excessive warnings, inducing excessive project liquidations, or insufficient warnings, inducing excessive continuations. The very fact that this information system results in inefficient continuation decisions allows managers to credibly convey to lenders that they will not engage in risk-shifting, and hence facilitates financing. We derive conditions under which the optimal system that deters risk-shifting generates excessive or insufficient early warnings relative to first-best.
Keywords: Commitment; Risk Shifting; information system; Early Warning
JEL Classification: G30; G32; M40; M41
Suggested Citation: Suggested Citation