A risk incentive problem for a lender and a borrower when an additional asset is used as security

A typical problem in financial contracting is the so-called risk-shifting incentive problem. In many cases, this problem in financial contracting, which typically arises in the context of a lender-borrower relationship, means the borrower’s incentive to influence the risk of his project. In particular, the shareholders of a levered firm will behave so as to maximize the value of their shares since the shareholders’ objectives do not necessarily coincide with firm value maximization when the firm is levered. However, a lender also may have a risk incentive under some circumstances; thus, he may make it difficult to carry out efficient debt renegotiation. We study not only the borrower’s risk incentive but also the lender’s risk incentive, and the relationship between both sides is studied since the lender’s risk incentive may generate the borrower’s risk incentive. Thus, when either side selects a risky project instead of a safe project, inefficiencies in resource allocation develop. In this paper, we focus on an effective financing strategy of a lender for which lender’s expected profit is valued by taking borrower’s risk incentive into account. The possibility of moral hazard raised by borrower’s firm is considered as a cause which the borrower himself may make agency cost high. In particular, when the lender perceives the possibility of risk incentive of the borrower he may impose to require more additional amount to be paid since the lender gets afraid of involving in a financial trouble. Then, the borrower will refrain from investing in the risky project, instead, he may use an additional asset as security to be able to maintain or recover his trust or credibility. Thus, it is shown that the existence of the additional asset will affect the borrower’s incentive. Through numerical simulations, we analyze the risk-shifting incentive problem, then the agency cost generated with the effect of an additional security is discussed, as a result the risk incentive problem may be mitigated. For our approach to analyse the process, option pricing theory is used and examined with some examples.