Risk Incentive Problems between a Lender & a Borrower and Possible Ways for Mitigation

Abstract A typical problem in financial contracting is the so-called risk-shifting problem, which has been studied in economics and finance. This problem, which usually arises in the context of a lender-borrower relationship, stands for the borrower's incentive to give influence to the risk of his project. In this study, lender's incentive as well as borrower's incentive is discussed since lender's incentive also influences the borrower and may make it difficult to carry out efficient debt negotiation when it is possible, as a result inefficiencies in resource allocation will develop. There are several ways to cope with the risk incentive problems. We attempt to show several alternatives to mitigate the problems. Our model is based on option theory for which the analyses may be different from others in the literature.