This article models debt market equilibrium given an expanded notion of rational behavior. The model extends Diamond's model of reputation acquisition, by assuming that some prospective borrowerinvestors are opportunistic utility maximizers, while others are unwilling to mislead borrowers as to their intended use of borrowed funds. We find that the presence of honest borrowers is necessary to the function of debt markets, and that, as in realworld markets, opportunistic and honest agents can coexist. We further find that total economic activity is positively correlated to the proportion of trustworthy agents. A major research concern in financial economics is the reconciliation of observed behavior with the predictions of the perfectmarkets, utilitymaximization models, which have traditionally supplied the dominant paradigm in finance. The main focus of recent research has been on the predictions of Agency Theory, or simply Agency Jensen and Meckling, 1976. Agency has its origins in the property rights literature of economic theory Alchian, 1969 and, in essence, addresses the following question How do rational agents act in imperfect markets A whole range of market imperfections have been analyzed ranging from the simplest type of moral hazard and adverse selection Thakor, 1989 to the debt capacity of an industry Maksimovic and Zechner, 1991. Indeed, few if any areas of business theory have escaped Agency's scrutiny it has, in effect, recast the theory of the firm. In this light, the firm becomes a structure whose efficiency depends upon its ability to mitigate the costs associated with Agency. Firms are legal fictions which serve as a nexus for a set of contracting relations among individuals Jensen and Meckling, 1976, p.310. One of the major gaps in the oneperiod models of agency behavior has been the inability of these models to explain management's honest behavior Thaler, 1992. That is, managers do not always engage in such rational acts as riskshifting, or paying excessive dividends, in order to enrich shareholders and themselves at the expense of bondholders. A significant move toward reconciling Agency's predictions with observed behavior has resulted from the reputationacquisition work of Diamond 1989, building on the work of Kreps and Wilson 1982 and Milgrom and Roberts 1982. In these models, agents acquire reputations by demonstrating some consistent mode of behavior through multiple iterations of a contractual situation. Through these iterations, principals modify their beliefs concerning the future behavior of the agent by observing certain outcomes. In Diamond's model, rational agents will not continually choose either a risky project or safe project. Their choice is a function of the interest rate and the stage of the game. Specifically, these agents choose the risky project initially then, as attrition among risktakers causes interest rates to drop, they shift to the safe project for some iterations. As the end of the game approaches, however, these agents once again revert to investing in the risky project. In comparison with the attention that has been devoted to identifying and analyzing market imperfections, the former part of the Agency question namely the rational agents part has attracted much less attention in the finance literature. In Agency models, rationality has been defined strictly in terms of the individual pursuit of pecuniary wealth. This expectedutility model has been tested experimentally and has been found to be systematically violated, in at least two fundamental ways 1 Individuals do not behave as if they are attempting to maximize wealth Plott, 1986, and 2 Individual behavior is affected by notions of fairness and cooperation Kahneman, et al, 1986. Attempts to construct a theory of capital market behavior which can accommodate this observed behavior are virtually nonexistent. This lack is probably due to the presumption that opportunistic agents will drive ethical agents out of the market. However, as we demonstrate in the model developed in this paper, this is not necessarily the case. By focusing attention specifically on Agency's rationality premise, the model developed here differs from antecedent Agency models. This article investigates the implication, for financialmarket equilibra, of an alternative rationality premise. We assume that some agents will display the virtues of honesty and trustworthiness in their dealings with Other agents. Modifying Diamond's 1989 model of reputation acquisition in debt markets, the impact of these virtuous agents on financialmarket equilibria is investigated. The model indicates that the existence of trustworthy agents in financial markets is not merely desirable from an economic perspective, but actually is essential if debt markets are not to fail. Specifically, if lenders do not belief that some nontrivial cohort of trustworthy agents exists, then lenders cease to lend and debt markets cease to function. Also, the greater the proportion of honest agents, the greater is the overall level of economic activity indeed, the existence of honest agents will tend to induce at least some of the opportunistic agents to act virtuously. We find that, as Bowie observes in a more general context, it only pays to lie or cheat when you can free ride off the honesty of others 1991, pp.1112. In addition, the belief in a nontrivial cohort of trustworthy agents can lead to the elimination of some agency problems.
Managerial Finance – Emerald Publishing
Published: Apr 1, 1996
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