Risk Sharing, Risk Spreading and Efficient Regulation

Initially contracts have been considered as a mechanism to save on transaction costs. However, over time they have come to be regarded a result of the need to share risks. Risks can be either exogenous to the contracting parties or generated by them (endogenous). In particular, information asymmetry creates adverse selection and exogenous randomness while endogenous randomness is due to moral hazard. The principal agent models essentially contain a formal characterization of risk sharing in contracts towards its efficiency. There is an acknowledgement that such sharing results in a propensity to take up more risky transactions and spread them to more individuals in various forms. Mature individuals are expected to regulate their activities and contain risks within acceptable bounds. Individual greed may however lead to systemic risks which are beyond their control. Efficient regulation must be conceptualized to move the system back to stability.

Two broad trends are discernible in the context of the development of scientific R&D. First, there is a significant increase in conference culture and the tendency of many authors rushing the dissemination of their discoveries. Second, there is an increase in the willingness to accept and finance such activities. Clearly, both these features tend to be sustainable only because the parties involved in the transactions feel that they have something to gain commercially. The primary purpose of this study is to examine this nexus utilizing a modified principal agent model. The existence of these mechanisms renders the national wealth more volatile. Such volatility can be minimized only if firms, that undertake commercialization, are adequately skilled and/or highly volatile transactions can be screened out by making it more expensive to commercialize them. The least that can be done is to discourage proven losers over time if they fail to self-select.

It is often necessary to combine formal knowledge (written down, blueprints) with informal knowledge (rules of thumb and heuristic adaptations required to scale up technology) to “work a patent.” Informal knowledge must be provided by the inventor through his participation. Adverse selection of partners and their personal interests (moral hazard) may create risks. These problems have been highlighted in the context of biotechnology in particular. An attempt has been made to model the sharing of knowledge, costs, and returns. R&D, that creates external effects, is generally entrusted to public scientific organizations and transferred to private firms for its adoption. The similarity of issues is highlighted. The advantages of risk sharing have been juxtaposed with dimensions of risk spreading that they involve.

Information asymmetry has a pivotal role in determining the nature of contractual arrangements of international joint ventures. In recognition of the risks associated therein, MNCs utilize resources to identify the information pertaining to the supply chain management and/or offer informal knowledge in the use of the technology transferred to their joint venture partners. There is, however, inadequate theoretical explanation of the channels through which such policies affect the choice of contract parameters (in particular, royalty rates) and how they influence the performance of joint ventures. This study argues that such policies reduce the variance associated with information asymmetry and thereby neutralize the deficiencies due to the lack of skills. This enables the MNCs to offer a uniform royalty contract to all their joint venture partners as reported in the empirical literature.

Information asymmetry and adverse selection are intrinsic to technology transfer across national boundaries. The MNCs therefore offer informal knowledge in the use of technology, in addition to formal technological details, to their joint venture partners. They also share in the capital investments to elicit greater commitment. Theoretical explanation of the channels through which such sharing affects the contract parameters is however inadequate. In particular, the existing models are mostly deterministic and do not account for hidden action on the part of the foreign firms and the associated uncertainty. The principal agent model offers a more suitable framework for analysis. Utilizing the framework of the principal agent model, this study argues that such policies reduce the variance associated with the risk and thereby neutralize deficiencies due to information asymmetry. From a strategic management perspective, this conclusion suggests that MNC policies directed to assessing and reducing overall environmental uncertainties, especially those related to firms in the industry and government policies, will be superior to the provision of firm-specific informal knowledge.

International joint ventures are subject to moral hazard and instability. Low IPR protection and inadequate enforcement account for such problems. Principal agent models account for the moral hazard in terms of the randomness in revenue generated. Equity sharing arrangements, which have important commitment and control effects, can be expected to eliminate the moral hazard and produce royalty arrangements consistent with empirically observed stylized facts. This study demonstrates that the change in the variance is the primary channel through which the commitment and control effects affect the choice of such royalty payments.

Why and how do contracting parties share variable and/or fixed costs? How are the revenue and cost sharing agreements affected by an expectation of premature termination? How will fixed assets be shared if dissolution occurs without prior notice? These and other related questions will be examined utilizing a synthetic principal agent framework. The analysis centers around three effects of cost sharing: integrity effect, incentive effect, and control effect. Though somewhat fragmented, the available empirical literature, pertaining to many areas of application, will be summarized to disentangle the forces behind cost sharing in contractual relations.

This study examines the extent to which warranties can represent risk sharing arrangements between consumers and the firm. In particular, we argue that this approach can explain limited warranties and limited warranty duration. The existing literature on warranties is ambivalent about the relationship between quality of products and warranties. In contrast, we argue that there is a definite relationship between warranties, technological complexity of products, and the degree to which consumers exercise due diligence in the use of the product. We also examine the relationship between warranty and the intensity of use by the consumer. It has also been demonstrated that risk aversion can explain the choice of extended warranties though the result is somewhat circumscribed. We also show that warranties and risk sharing aggravate the lemons problem instead of mitigating it.

Individuals tend to seek insurance to pass some risks on to the insurer when they expect large losses in the use of assets. The insurer can make his activity sustainable by pooling risks. If individuals can be expected to bear a greater fraction of the loss due to failure, they will be more diligent in the use of assets and reduce risks for which they are responsible. Similarly, efficient insurance policies may motivate individuals to reduce some forms of systemic risk especially when they are predictable. However, the increase in costs, associated with risks and the fulfillment of covenants designed to reduce them, invariably increases costs, reduces the equilibrium insurance coverage, and increases premiums. The residual systemic risk that cannot be absorbed by these policies and the necessity to generate wider and superior insurance service are at the basis of the call for regulation of the insurance business. The attempt made in this study is to examine the nature of efficient insurance in the presence of both types of risk, regulatory policy, and individual adaptations to them. Sharing risks through self-selection, optimal regulatory oversight, and insurance policies designed on such a basis can be efficient and offer a fairly wide coverage only against some individual-specific and limited systemic risks. In several contexts systemic risks and their origin cannot be predicted in advance. Efficient design of insurance to counter such risks may never really be possible since it is an ex ante specification.

The originator passing on the risks (or sharing risks) in financial transactions is the general end result of asset-based securitization. It can be shown that volatility (measured as the variance in the recovery of receivables) increases in at least four contexts. (a) The originator does not share the risk and consequently expands into high-risk activities to increase his business. This depends on the efficiency of the special purpose vehicle (SPV) in collecting receivables and how consideration is defined at the time of securitization. However, there will be limits on volatility beyond which the originator does not gain. (b) The size of any one securitized pool may be small compared to the total business of the SPV. Portfolio choice based on the risk-adjusted rate of return becomes important in such a context. In an expanding market, the originator and/or the SPV may find the risk-adjusted rate of return on securitization even higher with increasingly risky transactions. He will then expand into activities that increase the volatility of transactions. (c) The investor, who buys the pass-through certificates issued by the SPV, may find securitized transactions more attractive relative to conventional financial instruments either due to lower transaction costs, shorter time horizon over which they are recovered, or higher risk-adjusted rate of return. Even this has the effect of increasing the volatility of financial transactions. (d) The parties tend to utilize credit rating agencies to indicate the risks involved and reduce their adverse impact. However, their commercial interests may result in ratings that augment and spread risks instead of containing them within desirable limits.

The finances provided by foreign institutional investors (FII) can be viewed as one of the catalysts that can contribute to capital formation and economic progress. Such finances may also result in stock market gains unrelated to the underlying real economy fundamentals. In either case, there will be some gains to domestic investors. However, there are risks involved in attracting such financial flows. For, depending upon the economic conditions in their own country or opportunities as they arise elsewhere, the FII may withdraw prematurely. Gains to domestic investors will then be reduced. Regulatory regimes have the role of maximizing the share of benefits to domestic investors in the process of risk sharing. The present study conceptualizes this process in a modified principal agent model. Firstly, it will be shown that regulatory diligence and the maximum share of benefits to domestic investors depend on the degree of difficulty and costs involved in making regulatory adjustments in response to the perceived risks and risk aversion of domestic investors. Secondly, we modify the results taking into account the costs of absorbing the investments into the domestic productive system. It can be shown that a greater degree of regulatory diligence will be necessary to make sure that the expected share increase is commensurate with these costs. Thirdly, the effect of FII investments being withdrawn earlier than expected can be shown to depend on the speed with which the domestic economy can convert the financial gains to real returns. In particular, domestic investors may agree to a lower maximum share if the rate of absorption is high. Fourthly, the regulators allowing investments of FII may be sequential. That is, they may allow a low level of investment to begin with and increase the volumes only when the propensity to withdraw is not damaging to the domestic economy. This aspect will also be examined. Fifthly, we investigate the risk-spreading nature of these investments even when risks are shared within an efficient regulatory regime. Surely, all the practical details of implementing the regulatory measures cannot be fully incorporated in the present framework. Similarly, not all aspects of the distinction between purely financial (capital gains-related) returns and real returns can be captured. More work along these lines is warranted.

The recent financial crisis generated a great deal of debate about the necessity for, and the quantum of, bailouts. There is also a wide-ranging acknowledgment that prudential regulation is necessary to minimize the frequency and intensity of such systemic failures in the future. However, the existing analytical and policy studies tend to deal with these two aspects in isolation. By way of contrast, this study sets up an analytical framework to endogenously determine the requisite regulatory practices and bailout instruments to overcome the liquidity problems and the associated solvency problem on a long-term basis. Such efficient choices have been structured to resolve the trade-off between growth and stability by maximizing the welfare of all the parties. Prior knowledge that a well-defined bailout policy operates if they adhere to clearly specified regulatory norms signals to the financial institutions that keeping risks within bounds will be in the overall interests of all concerned.

The estimation of principal agent models is a subset of inverse optimal problems. As of now, there is no consistent method of estimating all its parameters. In general, some proxies for the parameters have been utilized to test plausible economic implications of such models. This study develops a method of estimation for all the parameters using a very limited time series data for one contracting pair. Progress toward empirical reality, based on stylized facts, has been achieved by iteratively modifying the theoretical models and econometric methods. One of these results provides a theoretical justification for the econometric tools utilized in practice as well. However, a fundamental modification of the underlying assumptions is necessary. Given the emphasis on contracts in economic exchange, it is necessary to develop the methods further. The study also outlines some of the pertinent issues.

This chapter assembles, in a summary fashion, the different sources of exogenous and endogenous randomness encountered in the various contractual contexts examined in the earlier chapters. These risks are essentially due to the attitudes of firms seeking larger market share in imperfect product markets, reducing the quality of products, attempting to make up the imperfection through warranties and insurance, and expanding their financial base through a variety of financial institutions and complex financial products. Attempts to cushion some risks eventually had the effect of increasing the overall risks in the system. Risk sharing activities generally tend to generate greater risk spreading as well. Such risk spreading through contracts has become so endemic that the efficiency of contracts relative to the market mechanism has been undermined. Contracts tend to be more fragile than markets whose inefficiencies they were expected to mitigate. Self-regulatory action by the contracting parties turned out to be inefficient. Regulatory action tends to offer short-term measures to overcome systemic instability in the hope that mature individuals in the contract will behave honorably and bring the system back to a stable equilibrium. However, it appears highly unlikely that the cost minimization originally envisaged can be achieved.