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76 RISK MANAGEMENT AND VALUE CREATION IN FINANCIAL INSTITUTIONS
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agement) to generate enough cash flows to meet the debt’s obligations.
This is especially important when no single influential
shareholder controls the management actions closely or plays an
active role in the firm’s management. On the other hand, there
are agency costs of debt that increase with leverage. 109 A higher
leverage increases the probability of default and, with it, increases
the (indirect) cost of default, that is, it lowers the market value
of the firm. Additionally, the higher interest rates charged by the
debt holders to reimburse them for the costs of writing and
monitoring collateral, covenants, and so on, especially when the
firm’s risk-profile changes or its leverage is further increased, are
also nontrivial. Jensen and Meckling 110 argue that there is an
optimal degree of leverage that minimizes the total agency costs
from the two sources. Moreover, the market for corporate control
111 and other mechanisms can lower both kinds of agency
costs.
Transaction-cost-based approach: Transaction costs are the costs that
are associated with the initiation, determination, transfer, enforcement,
and adaptation of contractual arrangements on property rights.
They are the result of asymmetric information (that leads to moral
hazard and adverse selection) and the limited rationality of the market
participants. These problems are resolved via ex post monitoring
structures, which are costly, because they try to remove these information
and incentive problems. The analysis of these costs can determine—based
on the difference in transaction costs—where trade
relationships should be exchanged. Depending on the specificity and
the frequency of a transaction, it can be more cost-efficient to do the
transaction in the open market or within a firm. 112
As can be seen from the above description of the various neoinstitutional
approaches, they all require, in one way or another, the relaxation of the
assumptions of the idealized neoclassical world to include the concerns of
the various stakeholders of a firm (such as, for example, transaction costs,
taxes, default costs, conflicts of interest that result from the fact that each
party cares only about the financial and nonfinancial advantages and disad-
109 These are, for example, asset substitution and underinvestment and will be described
in more detail below.
110 See Jensen and Meckling (1976), p. 344. However, they analyze each branch of
the problem set in isolation to derive their equilibrium. Modern theory would require
deriving an integrated solution, which could be very different.
111 As described above and, for example, by Jensen (1993).
112 See for example, Jensen and Meckling (1991).