Financial Markets and Institutions (2-downloads)

compatible; that is, it aligns the incentives of the borrower with those of the lender.

The greater the borrower’s net worth and collateral pledged, the greater the bor-

rower’s incentive to behave in the way that the lender expects and desires, the smaller

the moral hazard problem in the debt contract, and the easier it is for the firm or

household to borrow. Conversely, when the borrower’s net worth and collateral are

lower, the moral hazard problem is greater, and it is harder to borrow.

Monitoring and Enforcement of Restrictive Covenants

As the example of Steve

and his ice cream store shows, if you could make sure that Steve doesn’t invest in

anything riskier than the ice cream store, it would be worth your while to make him

the loan. You can ensure that Steve uses your money for the purpose you want it

to be used for by writing provisions (restrictive covenants) into the debt contract that

restrict his firm’s activities. By monitoring Steve’s activities to see whether he is com-

plying with the restrictive covenants and enforcing the covenants if he is not, you can

make sure that he will not take on risks at your expense. Restrictive covenants are

directed at reducing moral hazard either by ruling out undesirable behavior or by

encouraging desirable behavior. There are four types of restrictive covenants that

achieve this objective: