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North–South Lending with Moral Hazard and Repudiation Risk
Author(s) -
Lane Philip R.
Publication year - 1999
Publication title -
review of international economics
Language(s) - English
Resource type - Journals
SCImago Journal Rank - 0.513
H-Index - 58
eISSN - 1467-9396
pISSN - 0965-7576
DOI - 10.1111/1467-9396.00145
Subject(s) - moral hazard , debtor , incentive , investment (military) , economics , morale hazard , order (exchange) , realization (probability) , actuarial science , microeconomics , monetary economics , business , finance , creditor , law , political science , risk pool , debt , insurance policy , statistics , mathematics , casualty insurance , politics
The paper shows that the joint presence of moral hazard and repudiation risk generates an important interaction effect. In order to provide the proper incentives to borrowers, the optimal financial contract under moral hazard calls for all available resources to be paid to the lender in the event of a poor realization for output. Repudiation risk limits the size of this transfer, as the debtor has the option to default. This upper bound on the resource transfer exacerbates the moral hazard problem, reducing lending and the equilibrium level of investment and output.