Explain the meaning of the concept of moral hazard and why it explains that debt contracts are complicated legal documents that place substantial restrictions on the behaviour of the borrower (also list the four types of restrictive covenants). Are monitoring and restrictive covenants necessarily effective? Can you explain why financial intermediaries play a more important role in channeling funds from lenders → borrowers than marketable securities?
A moral hazard is the asymmetric information problem that occurs after the financial transaction takes place, when the seller of a security may have incentives to hide information and engage in activities that are undesirable for the purchaser of the security. Debt contracts provide contractual agreements between the borrower and the lender, which will encourage the borrower to pay the lender a fixed dollar amount at periodic intervals. The lender is not interested in the activities of the borrower for as long it receives its interest and periodic payments in time. It is only when the firm is in a state of default when the lender will be concerned and interested in verifying the firm’s profits.
The four different restrictive contracts used in debt contracts to reduce moral hazard can be restrictive or enforcing covenants. These covenants are explained below:
- Covenants to discourage undesirable behavior – these covenants try to reduce desirable behavior on the side of the borrower by restricting the borrower from engaging in undesirable behavior, like undertaking risky investment projects. These kinds of covenants give the borrower a mandate to use the loan only on specified activities and thus restricting engaging in certain businesses.
- Covenants to encourage desirable behavior – these kinds of restrictive covenants will encourage the borrower to engage in desirable activities that make it more likely that the loan will be paid off. Restrictive covenants of this type for businesses focus on encouraging the borrowing firm to keep its net worth high because higher borrower net worth reduces moral hazard and makes it less likely that the lender will suffer losses.
- Covenants to keep collateral valuable – these kinds of covenants will encourage the borrower to keep collateral in good condition and to make sure that it stays in good condition and in the possession of the borrower. Automobile loan contracts, for example, require the car owner to maintain a minimum amount of collision and theft insurance and prevent the sale of the car unless the loan is paid off.
- Covenants to provide information – these kinds of covenants will require the borrower to provide information about its activities for periodic reviews in the form of accounting and income reports, thereby making it easier for the lender to monitor and reduce moral hazard. This covenant gives the lender the right to audit and inspect the borrower’s books at any time.
As shown by all these covenant agreements to reduce moral hazard, we can now acknowledge that debt contracts are often complicated legal documents with numerous restrictions on the borrower’s behavior. Debt contracts require complicated restrictive contracts to lower moral hazard.
Are debt covenants effective?
Although restrictive covenants help to reduce the moral hazard problem, they do not eliminate the moral hazard problem completely. One other thing that makes the debt covenants, is that the borrower will be always the look for loopholes in the restrictive covenants, thus making them less effective. Debt covenants just like equity finance require monitoring because the covenants will be useless when the borrower knows that he can violet the covenant because the lender will not be monitoring. The cost of monitoring can be high, more especially when another cost has been incurred in designing the debt contracts.
Why financial intermediaries are important in channeling funds as compared to securities markets.
Free raider problem
Financial intermediaries particularly banks have the ability to avoid the free raider problem through offering private loans. Through private loans, banks can maximize the advantages of monitoring and enforcement which will help in reducing the problem of moral hazard inherent in debt contracts. By avoiding the problem of moral hazard through the provision of private loans, we find another reason why financial intermediaries still play an important role in channeling funds from savers to borrowers as compared to marketable securities.