Fragility under joint financing: The (moral) hazards of diversification

Abstract

We study the effect of investment growth on firms' incentives under moral hazard. Adding value-increasing, but risky projects to a firm's portfolio can weaken incentives for safer ones, even when returns are independent. While the firm diversifies its sources of income, this risk contamination channel can increase its fragility. Such fragility is exacerbated in the presence of news about the value of investments. Firms can mitigate these effects by selecting safer new investments at the expense of value creation. Our model thus predicts that large firms or merged firms may be riskier or less productive than smaller firms.