Early Warning Signals and Risk-Shifting Incentives

41 Pages Posted: 17 Aug 2019 Last revised: 18 Mar 2021

See all articles by Volker Laux

Volker Laux

University of Texas at Austin - McCombs School of Business

Ronghuo Zheng

The University of Texas at Austin - McCombs School of Business

Date Written: March 5, 2021

Abstract

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

Laux, Volker and Zheng, Ronghuo, Early Warning Signals and Risk-Shifting Incentives (March 5, 2021). Available at SSRN: https://ssrn.com/abstract=3437073 or http://dx.doi.org/10.2139/ssrn.3437073

Volker Laux

University of Texas at Austin - McCombs School of Business ( email )

2317 Speedway
Austin, TX 78712
United States

Ronghuo Zheng (Contact Author)

The University of Texas at Austin - McCombs School of Business ( email )

Austin, TX 78712
United States

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