Contractual externalities and systemic risk

Abstract

We study effort and risk-taking behaviour in an economy with a continuum of principal-agent pairs where each agent exerts costly hidden effort. Principals write contracts based on both absolute and relative performance evaluations (APE and RPE, respectively) to make individually optimal risk-return trade-offs but do not take into account their impact on endogenously determined aggregate variables. This results in contractual externalities when these aggregate variables are used as benchmarks in contracts. Contractual externalities have welfare changing effects when principals put too much weight on APE or RPE due to information frictions. Relative to the second best, if the expected productivity is high, risk-averse principals over-incentivize their own agents, triggering a rat race in effort exertion, resulting in over-investment in effort and excessive exposure to industry risks. The opposite occurs when the expected productivity is low, inducing pro-cyclical investment and risk-taking behaviours.