Academic journal article European Research Studies

How Is Moral Hazard Related to Financing R&D and Innovations?

Academic journal article European Research Studies

How Is Moral Hazard Related to Financing R&D and Innovations?

Article excerpt

1. Introduction

The moral hazard has a potential to arise through the information asymmetry between suppliers of funds to Research and Development (R&D) and technological innovation projects (2), and the borrowing firms owning these projects (Svensson, 2013). Here, the wealth-constrained firm controls the allocation of the borrowed funds but the investment effort put to the R&D activities is unobservable to the supplier of funds. This information asymmetry exacerbates the interest asymmetry and thus creates moral hazard if insiders divert cash flows from external funds to their own benefits instead. Moreover, the information asymmetry is further reinforced, as firms are reluctant to reveal the progress of their R&D projects with a fear of spillovers to competitors due to non-excludability (Anton and Yao, 1998).

The specific research objective of this study is to investigate which corporate governance and firm-specific characteristics lead firms to be prone to ex-post moral hazard by misallocating the funds that they specifically borrowed for financing their R&D activities. We study 106 firms that have received a specially designed loan by Turkish government to be invested in their R&D activities. Here, the supplier of funds is not a profit-seeker agent but a performance-seeking agent. The long-term objective of the government to lend this loan is increasing the performance and uniqueness of goods produced in the domestic market and ultimately contributing to the solution of the country's chronic current account deficit problem. Moral hazard is a special case of information asymmetry where the decision of one party with superior information is at the detriment of another after a transaction has taken place. In our case, after this specially designed loan by the government is acquired, the decision to use this loan efficiently belongs to the firm, which has superior information and do not carry the full burden of potential losses. Through establishing a link between moral hazard and efficient usage of these loans, we also contribute to literature by testing the two contradictory theories, namely "stewardship theory" and "agency theory".

For our study, another factor exacerbating the moral hazard problem is, the loans given out to these firms by the Turkish government have longer maturity compared to other sources of external finance available to them. However, debt with shorter maturity requires more frequent negotiations therefore provides more monitoring so that lenders can protect their claims from the borrower's moral hazard incentive (Arslan and Karan, 2006; Aren at al. 2012). Consequently, these loans have less potential to play an effective role in pre-committing investors to punish the low efforts of firms.

To our knowledge, there is no prior study looking at the direct role of moral hazard in financing R&D and innovations. The closest to ours is the study by Svensson (2013) who focuses on the nature of the contract terms as a remedy for the moral hazard arising between owners of the patents and their external financiers. Other studies tackle the moral hazard between entrepreneurs and venture capitalists. Chan et al. (1990) explain the optimal transition of control between entrepreneur and venture capitalist in a model with initial uncertainty about the skill of the entrepreneur. Similarly Bergemann and Hege (1998) states that optimal contract between entrepreneur and venture capitalist should be different from a standard debt contract given that entrepreneur's effort is not verifiable.

Our results show that as the size of the loan increases firms are less prone to moral hazard. For family firms, our results support the agency theory. For large shareholders, initially our results are aligned with the agency theory but after controlling for the loan size our results hold for the stewardship theory. Finally we find that as the amount of loan increases relative to the size of a firm, the performance of projects financed by these loans fall and the performance varies across different industries. …

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