Success Repayable Loan under information asymmetry

63

difficulty in determining such when there is information asymmetry and the current system has a fixed level of for policy convenience, which leaves open the possibility of the Success Repayable Loan not achieving its intended purpose even under information symmetry. Since means that , in terms of a company, will be less risky than and at the same time will become an exploration project company with higher expected returns, so both risk-neutral and risk-averse firms will prefer . In other words, there may be some risk-neutral and risk-averse companies willing to undertake an exploration project that would abandon that same project under the general loan system. However, since an investor cannot recover the entire expected loss, the Success Repayable Loan System will become unsustainable in the long term. If , then , and will become an exploration project company with lower expected returns (although with less risk than ), meaning that all risk-neutral companies will prefer (general loan). In the case of risk- averse firms, whether or not for a given is satisfied depends on the firms’ degree of risk-aversion. In other words, relatively risk-averse firms prefer the Success Repayable Loan, while those that are relatively less risk-averse tend to favor a general loan.

64

Regardless of the success of the exploration projects, the companies must repay their loan principals under the general loan system. Therefore, there is no adverse selection under the general loan system, as long as the repayment of principal is always guaranteed through the legal system, even in the case of failure. Under the general loan system, the problem with the exploration projects of companies h and l can be summarized as follows.

(20)

Therefore, the investors’ principal and interest for is secured at all times, regardless of the success or failure of the projects. Neither company thus has any incentive to distort its probability of success, with each deciding whether to carry out their exploration project after calculating the expected utility of the project. For example, all else being equal, if the two companies have the same degree of risk-aversion, a that satisfies will exist, meaning that company h will carry out its project while company l will not.

However, under the Success Repayable Loan system, the investors share the losses in the case of project failure, so there is incentive for companies like company l with a low probability of success to participate in a project. To confirm this, we can summarize the problem with an exploration project loan of companies h and l under the Success Repayable Loan system as follows.

(21)

However, what investors regard as the problem with exploration company i’s exploration project financing is as follows.

(22)

At this time, if , the relationship will hold. Since the purpose of the investors’ implementation of the Success Repayable Loan system, rather than a general loan, is to support the

65

risk-taking of a company with the same expected return, as discussed in the previous section, the investors choose to cover the exact expected losses under the Success Repayable Loan. Therefore, the set by the investors for any given from Equation (16) is determined as follows.

(23)

However, for companies h and l, the special charge rates ( and ) that make a general loan become the MPS of the Success Repayable Loan are as follows.

(24)

Since , the relationship will hold. In this case, if all companies are risk-neutral, the problem of adverse selection will become clear. In other words, for any given , the set by the investor will be less than the value that must be imposed on company l, meaning that the exploration project guarantees company l a greater expected return than under a general loan (i.e., ) and thus induces company l to choose the Success Repayable Loan. On the other hand, since is higher than the value that should be imposed on company h, the exploration project will guarantee a lower expected return for company h than under a general loan (i.e., ), inducing company h to choose a general loan. Therefore, because only company l will remain in the Success Repayable Loan market, the problem of adverse selection becomes clear.

This discussion is summarized in Figure 4-3. The constraint line given by risk-neutral investors under information asymmetry is a combination of , which appears as a straight line with a slope of

, as shown in the figure. Since companies h and l are both risk-neutral, the indifference curves appear

as straight lines, and the slope of the indifference curve of company h is , and the slope of the

indifference curve of company l is . As we have seen, since , the slope of the

66

indifference curve of company h is more moderate than that of the constraint line, while the slope of the indifference curve of company l is steeper than that of the constraint line. Thus, under information asymmetry, the optimal choice of company h is , referring to a general loan, while the optimal choice of company l is , referring to the Success Repayable Loan with a current repayment exemption rate of 100%.

However, if the exploration firm is risk-averse, the problem of adverse selection will emerge, but there is a possibility that the problem will not be as serious as in the case of a risk-neutral company. If the companies are risk-averse, the indifference curve of each company on the plane is concave to the origin, meaning that as you go closer to the origin, the expected utility increases. In addition, the more risk-averse the company, the steeper the slope of the indifference curve. In this case, since set by an investor for any given is lower than the value that should be imposed on company l, the exploration project under the Success Repayable Loan is not only less risky for company l, but also gives a higher expected profit, thereby providing greater incentive to participate than a general loan. That is, holds for a given . In other words, as in the case of a risk-neutral company, company l will choose the Success Repayable Loan instead of a general loan.

However, in the case of company h, since the Success Repayable Loan generates a lower expected return but exposes the company to less risk than a general loan, there is still an incentive for the company to participate, depending on the degree of risk-aversion. That is, for a given , can still hold, depending on the degree of risk-aversion of company h. In other words, company h (if it is risk-neutral) always favors a general loan, although there is still a possibility (if it is risk-averse) that it might choose the Success Repayable Loan, depending on its degree of risk-aversion. For example, a very risk-averse company h may still prefer the Success Repayable Loan. Therefore, the Success Repayable Loan system can cause the problem of adverse selection in that it increases the incentive of company l (which should not participate) to participate while reducing the incentive of company h (which should participate) to participate. However, there is still a possibility that company h, depending on its degree of risk-aversion, may participate in the Success Repayable Loan market.

Figure 4-3. Risk-neutral (adverse selection)

67

원문 번역문

성공확률 낮은 기업의 최적선택 Optimum choice of a company with a low probability of success

성공확률 높은 기업의 최적선택 Optimum choice of a company with a high probability

of success

기울기 Slope

성공확률 낮은 기업의 무차별곡선 (risk-neutral) Indifference curve of companies with low probabilities of success (risk-neutral) 비대칭정보 하에서의 투자자에 의해 주어진

제약선

Constraint line given by investors under information asymmetry

성공확률 높은 기업의 무차별곡선 (risk-neutral) Indifference curve of companies with high probabilities of success (risk-neutral)

This discussion is highlighted in Figure 4-4, where the very risk-averse company l, which would select a partial Success Repayable Loan for risk-sharing purposes under information symmetry, can increase its expected utility by choosing the Success Repayable Loan with a debt exemption rate of 100% under information asymmetry.

Here, we find that the very risk-averse company h, which would select the Success Repayable Loan with a debt exemption rate of 100% under information symmetry also chooses the Success Repayable Loan with a debt exemption rate of 100% as its optimal selection under information asymmetry, although its expected utility is decreased due to adverse selection. Therefore, this confirms that, in relation to risk-sharing, the extent of the adverse selection problem depends on the degree of the company’s risk-aversion. It thus follows that, as the degree of risk aversion increases, the less serious the adverse selection problem is than expected.

Figure 4-4. Risk-averse (information symmetry)

68

원문 번역문

기울기 Slope

대칭적 정보 하에서 투자자에 의해 주어진 성공확률 낮은 기업의 제약선

Constraint line of a firm with a low probability of success given by an investor under information symmetry

비대칭정보 하에서의 투자자에 의해 주어진 제약선

Constraint line of a firm given by an investor under information asymmetry

대칭적 정보 하에서 투자자에 의해 주어진 성공확률 높은 기업의 제약선

Constraint line of a firm with a high probability of success given by an investor under information symmetry

성공확률 높은 기업의 무차별곡선(매우 위험기피적)

Indifference curve of a firm with a high probability of success (very risk-averse)

성공확률 낮은 기업의 무차별곡선(매우 위험기피적)

Indifference curve of a firm with a low probability of success (very risk-averse)

These results are a natural consequence of the key factors of the Success Repayable Loan system. In the case of information asymmetry, from the perspective of company h, the Success Repayable Loan has the negative effect of lowering its expected return compared to a general loan, while it has the positive effect of allowing all or part of its failure risk to be shared by the investor. Thus, whether company h remains attracted to the Success Repayable Loan will depend on the magnitude of the two opposing effects and, more fundamentally, the degree of company h’s risk-aversion. This discussion is consistent with Dowd (1994)’s argument that a financing scheme in the form of limited debt reimbursement (limited liability) may be the optimal contract for a risk-averse debtor.

Meanwhile, since the fundamental purpose of the Success Repayable Loan system is risk-sharing for high-risk projects, we have to assume that exploration companies (both today and in the past) are risk-averse. If so, the

69

possibility for adverse selection remains open, but the degree of adverse selection is expected to be lower if the situation is risk-neutral. Therefore, it is problematic to underestimate the social contribution of the Success Repayable Loan due to the existence of the adverse selection problem, considering the basic purpose of the Success Repayable Loan system. Any assessment must thus be based on a comprehensive evaluation of both the negative effects of adverse selection and other problems and the positive effects of risk-sharing and other such benefits.

2) Success Repayable Loan and moral hazard

One of the most serious criticisms of the Success Repayable Loan system is that it has the potential to increase moral hazard compared to general debt contracts. In this section, we examine whether the problem of moral hazard in the Success Repayable Loan system is greater than that of a general loan, using a simple model, and identify ways for investors to mitigate such problems. To this end, we first analyze the case where an investor’s constraint to make his expected loss equal to his expected return under the Success Repayable Loan system is not considered and then analyze the results derived from the case where said constraint is considered.

Suppose that the probability of success of an exploration project introduced in the previous model now depends on the level of effort ( ) of the exploration company. Here, it is assumed that an increase in the exploration firm’s effort increases the probability of success, but the magnitude of the success probability decreases as the effort increases. That is, we assume and . We also assume that the exploration company has no chance of success if it makes no effort at all (i.e., ), and there is no guarantee of complete success even if it puts in maximum effort (i.e., ). Since the firm’s effort is related to its costs, the utility function of the firm is determined based on its profit and effort. It is assumed that the utility function of the exploration company can be separated into a utility function based on profit and a disutility function based on effort. In other words, the utility of the exploration firm can be defined as follows.

(25)

, where , , , and are assumed. Moreover, is assumed

as well. Therefore, the general loan ( ) we reviewed above can be redefined as follows.

(26)

70

The exploration firm will determine its level of effort to maximize its expected utility.

(27) The first- and second-order conditions of this problem can be derived as follows.

(28)

, where is the optimal level of effort of an exploration company under a general loan. Through the first- order condition, we can easily confirm that the optimal level of effort matches the marginal disutility of effort with the expected marginal net utility.

If we define the Success Repayable Loan ( ) similarly, the problem of maximizing the utility of the exploration company can be expressed as follows.

(29)

The first- and second-order conditions of this problem are derived as follows.

(30) represents the optimum level of effort of an exploration company under the Success Repayable Loan. Since , , and under a meaningful Success Repayable Loan system, the following relationship will hold.

71

(31)

Thus, the relation of holds as well, and since and , then .

Therefore, if an exploration company is risk-neutral or risk-averse, it can be confirmed that there is a moral hazard problem that reduces the level of effort of the company compared to a general loan. However, what matters is the seriousness of such moral hazard. How much more serious moral hazard is under the Success Repayable Loan than under a general loan can be measured by the magnitude of the following.

(32)

It can be easily confirmed that the magnitude depends on the utility function of the exploration company, the excess return ( , imposed by the investor), the debt exemption rate ( , upon project failure), and the equity ratio capital ( ) of the exploration company.⁵¹ A comparative static analysis of major institutional variables is as follows.

(33)

The last inequality in the above equations is due to . Therefore, it can be confirmed that moral hazard under the Success Repayable Loan system worsens as the excess return (imposed by an investor) and debt exemption rate increase and the equity ratio of the exploration company decreases. As discussed by Jihyo Kim

51 The last of the above equations follows the one defined as for the preceding discussion.

72

and Yoonkyung Kim (2013), the theoretical prediction that the excess return increases as moral hazard worsens can be interpreted as showing that the claim of the National Assembly Budget Office (2006) that the excess return contingent upon project success should be increased due to the problem of moral hazard is, in fact, undesirable.

However, this result is a marginal effect of excess return in a situation where the debt exemption rate and capital adequacy ratio are fixed. As shown by the simulation analysis below, if the investor decides both the debt exemption rate and excess return together with the aim of making the expected loss equal to the expected return, it is possible to reduce the degree of moral hazard under the Success Repayable Loan system by adjusting the debt exemption rate and excess return.

Also, the most important consideration in an exploration project is the relationship between effort and success probability. If effort is the only variable that determines the probability of success, moral hazard can be a very serious problem, but even if effort has a limited effect on the probability of success, due to the nature of the given exploration project, moral hazard can still occur under the Success Repayable Loan system. It may not be reasonable to claim that the Success Repayable Loan system is undesirable in light of the above fact that moral hazard can occur under it.

Efforts and success probability of an exploration company

The risk of an exploration company can be divided into technological, commercial, and political risks.

Technological risk can be subdivided into geopolitical risk and uncertainty regarding exploration technology.

Examples of these risks include failure to find economically viable resources, exploration costs that are higher than expected, and discovery of a potential resource reserve for which commercial production is not possible due to technological limitations.

Often, 80% of E&P industry funds are spent for external purposes through service companies. The exploration company’s effort can be thought of as hiring a higher-cost service company with more advanced technology. An exploration project with regional characteristics is operated by an exploration team composed of general exploration experts and local experts, and hiring higher quality and more expensive professionals, instead of managing skills for these experts, can be a barometer of success.

However, companies with prior experience in exploration activities, including major corporations such as SK Co., Ltd., do utilize such service companies in their development projects, but they often tend to use their own internal manpower in the exploration phase. This case should thus be applied with caution.

73

Since the above discussion provides a basis for simulation analysis on the optimal level of effort and success probability under the general loan and Success Repayable Loan systems, according to the equity ratio ( ) of given institutional variables ( ) and the risk aversion of the given exploration company, we will go further and conduct a simulation analysis using a specific function type and some numerical values.

Let the disutility function according to the firm’s level of effort ( ) be , and

and will be satisfied. To assume that moral hazard can occur under the Success Repayable Loan, let us define a form of where the probability of an exploration company’s success will be greatly influenced by the effort of the company.

Considering that the probability of success of a general exploration project is very low, if the probability of

success according to a company’s effort is defined as , then and

will be satisfied.⁵² That is, we establish the success probability function defined as a

function of effort so as to satisfy .⁵³ As in the previous example in Section 4, we let the profit at success be , the profit at failure be , and the total investment be .⁵⁴

Tables 4-2 to 4-5 below are the result of a simulation analysis conducted by applying the Von Neumann-

Morgenstern utility function , assuming constant absolute risk-aversion (CARA).

In this case, the constant represents the absolute risk-aversion coefficient, where the larger the value, the more risk-aversion there is. For our analysis of the Success Repayable Loan, we conducted two analyses with the excess return set at 30%, this is: the Success Repayable Loan with a debt exemption rate of 100% ( ), and the Success Repayable Loan with a debt exemption rate of 70% ( ), which is an improved system.

Here, we find that the more risk-averse a firm is, the stronger its preference for the Success Repayable Loan

52 Due to the function form of , the probability of success will rise sharply if a company’s effort increases slightly above zero. Although the functions of this type may be very far from reality, we assume them in order to establish a state where moral hazard is likely to occur under the Success Repayable Loan.

53 Even if we let the success probability function be , the basic implication of this simulation analysis will not change.

54 At this time, the unit of currency is assumed to be one billion.