Precautionary Savings and Investment Incentives Under Moral Hazards

Dilip Mookherjee, Debraj Ray and Kunal Sengupta are thankfully acknowledged. 2 Abstract: The purpose of this paper is to examine the impact of financial intermediation on precautionary savings and incentives to invest in a setting where the credit market is subject to informational asymmetry due to moral hazard. We show that precautionary savings are the outcome of financial contracts that offer incomplete insurance. However, such a provision of incomplete insurance generates incentives to invest. The magnitude of investment and precautionary savings depend on risk bearing and insurance effects accompanied by financial contracts. The first effect enhances the incentive to invest and the second one has a dampening effect on investment. We also find that in a richer economy the former effect dominates so that incentive to invest is greater and the precautionary savings is smaller. We also make comparison in between three different financial regimes. (a) Financial autarky (b) Full information and (c) informationally constrained financial markets. We find that sufficient condition for financial markets to exist is the decreasing absolute risk aversion of agents. In the event financial markets exist under moral hazard, precautionary savings are lower than financial autarky. However, such a fall in savings is accompanied by a rise in current investment via a reallocation of resources from savings in safe deposits to risky investment. Such a substitution of assets towards investment occurs because intermediation improves the risk bearing capacity of risk averse individuals. We also find that such incentives are greater in a full information regime than informationally constrained credit markets where this risk bearing effect generated directly by fall in savings is partly mitigated by self insurance effects. Finally, it is shown that introduction of intermediation is welfare improving irrespective of its effect on investment .