Introduction to the Special Issue on “Financial Contracting: Theory and Evidence”

In April 2007, the Journal of Financial Intermediation, the University of Mannheim, and the European Corporate Governance Institute organized a conference on financial contracting at the University of Mannheim (Germany). This conference was generously funded by the German National Science Foundation (DFG) through the Special Research Center SFB 504 at Mannheim University. The conference attracted more than 100 submissions out of which 10 were selected for presentation in Mannheim. A total of 14 papers were submitted for editorial review at the Journal of Financial Intermediation. All of these 14 submissions were subjected to the journal’s usual double-blind refereeing procedure and six submissions were eventually selected for publication. They are collected in this special issue. These papers provide a nice mix of topics, ranging from banking regulation to international law and finance and corporate finance, and are, by coincidence, even equally divided between theoretical and empirical contributions. They all show, like the other papers presented in Mannheim, how theory and empirics can inform each other and how this interaction stimulates research. This interaction is all the more important in applications of contract theory, where endogeneity is the crux of all empirical work, which therefore needs to be theory-based in order to identify its relations. Vice versa, the well-known tendency of game and contract theory to ‘‘explain everything, explain nothing” (Sutton) requires contract theorists to constantly confront their ideas with empirical work. The Mannheim conference and the papers assembled in this volume are a great example of this kind of interaction. The volume opens with a paper by Martin Hellwig who re-examines the famous Jensen–Meckling theory of ‘‘agency costs” in financial contracting. This paper was initially written in the early 1990s but never published, and has become a secret classic of financial contracting theory. Its starting point is very simple. Jensen and Meckling’s (1976) proposition can be summarized by the statement that the issuance of different kinds of financial securities induces different types of moral hazard on the side of the issuer, and that the optimal mix of securities issued should minimize the sum of all these ‘‘agency costs”. In particular, debt tends to induce excessive risk-taking, while equity tends to induce insufficient managerial effort. As a corollary, Jensen and Meckling’s article has often been interpreted as providing a theory of capital structure. Hellwig notes that it makes little sense to add costs that arise from interrelated phenomena and that the impact of a combination of return schedules can only be understood by analyzing the incentives resulting from the whole package. In particular, reduced effort as a response to insufficient equity participation can generate incentives for excessive risk-taking, so that one incentive problem can aggravate the other. Hellwig therefore writes down an explicit version of the two-dimensional moral hazard problem that Jensen and Meckling had in mind. Interestingly, only few general results are available, most importantly that at a second-best contract there will be excessive risk-taking. Further results, on investment levels and effort provision, depend on the specification of the production function. An interpretation of the optimal incentive scheme in terms of debt and equity is possible only if outcomes can be observed without too much noise.