Risk Sharing as an Alternative to Debt 105
and informational issues. Agency issues arise because of asymmetric infor-
mation between agents (entrepreneurs) and principals (investors) and the
possibility that the agent’s utility maximization may not maximize the utility
of the principal. The agency problem is normally addressed by incorporat-
ing incentive structures in contracts for the complete sharing of information
and for the agent to behave in a way to maximize rewards for the principal.
In addition, there are implications on risk transfer, cooperation among
economic agents, and the stability of a fi nancial system when risk sharing is
widespread and encouraged across the system.
Reduced Information and Agency Problems
Informational and agency problems have generally been discussed in the
context of one risk/reward sharing instrument: equity. Stiglitz (1989), for
example, suggests that there are two informational problems in such cases:
(i) an adverse signaling effect, which leads good fi rms not to issue as much
equity as they might wish to for fear that it may signal poor quality; and
(ii) an adverse incentive effect, which suggests that equity fi nance weakens
the incentive for the entrepreneurs (agents) to exert their maximum effort
for the highest maximum joint returns for themselves and their shareholders
(principals). This happens because once the project is fi nanced, the entre-
preneur knows that the net return will have to be shared with the fi nancier
(the principal) and, therefore, may not have a strong motivation to work as
hard as when the return is not shared. There are also agency and informa-
tional problems in interest - rate based debt fi nancing. Stiglitz points out that
there is an inherent agency confl ict in debt fi nancing in that the entrepre-
neur (the agent) is interested in the high end of the risk–return distribution.
The lender (the principal) on the other hand, interested in safety, focuses
on the low end of the risk–return distribution, and therefore discourages
risk taking. This, Stiglitz asserts (p.57), has “deleterious consequences for
the economy.” He further suggests that “from a social point of view equity
has a distinct advantage: because risks are shared between the entrepreneur
and the capital provider, the fi rm will not cut back production as much as it
would with debt fi nancing if there is downturn in the economy.”
The agency problem has been generalized to bank lending. Banks, being
highly leveraged institutions that borrow short (deposits) and lend long, are
exposed to an asset–liability mismatch that creates potential for liquidity
shocks and instability. Stiglitz (1989) suggests that to protect their fi nan-
cial resources, banks generally discourage risk taking. Additionally, their
behavior toward risk often creates informational problems that lead to
phenomena that can be classifi ed as market failure, such as credit ration-
ing. By contrast, Hellwig (1998: 335) argues that there is an oft - neglected
informational problem in the lending behavior of banks, which he refers
to as “negative incentive effects on the choice of risk inherent in the moral
hazard of riskiness of the lending strategy of banks.” This risk materialized