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a case, loan rates are effectively balanced between different banks, and aggregate behavior is similar to the homogeneous intermediaries. The systemic impact of Lehman’s collapse is an illustration of how the dysfunction of the interbank markets can accentuate the depression of aggregate activity.

When liquidity becomes rare on financial markets, the problem of agency may also restrict the availability of equity financing for the bank. Taking into account the effects of their own liability structure, banks generally prefer to favor debt financing and turn away from outside-equity. As a result, the features of aggregate balance sheets tend to be excessively leveraged, Korinek (2009). Even though, credit policy is illustrated to stabilize volatility, it decreases the banks’ intensive to resort to outside equity financing. In turn, the aggregate leverage in the banking sector is lifted, and another financial crisis becomes more likely to occur. Therefore, further government intervention might be required, hence worsening moral hazard problems.

FUTURE CASH FLOWS AND MANAGERIAL INPUTS

One of the key objectives of financial economics is to advice companies on how to make a decision with regard to alternative investment opportunities. Financial theory sets the rule of net present value (NPV), and warns that investment decisions ought to be taken when the present value of the project expected cash flows exceeds the investment cost. Nevertheless, if the NPV role is “naively applied”; it is not responsible for the misleading information, as well as incentive problems that might occur in a “decentralized firm” (Bernardo, Cai and Luo, 2001).

Particularly, the head office of a firm might have to trust the given information about the future cash flows. Additionally, future cash flow of a project might depend on unobservable “managerial input”. Because, it is expected that the headquarter of a firm ought to trust the given information about the future cash flows, and the future cash flows of a project might depend on unobservable “managerial input” (Bernardo, Cai and Luo, 2001), the incentive and information problem might occur in a way that managers in the firm’s subsidiaries might report unverifiable project quality to the central office (headquarters), resulting in misguided capital allocation. Having allocated capital for the project, essential inputs such as effort is generated by the managers. The cash flows of the project are enhanced, but not verifiable by the headquarters. Additionally, Managers usually report the maximum quality of the project to gain a greater capital allocation, and they also put a minimum effort into the project to minimize their private cost (Bernardo, Cai and Luo, 2001).

For instance, incentive of managers to exaggerate the quality of the project might be mitigated by efficient allocation of capital, and optimal incentive-based compensation. Furthermore, moral hazard might be mitigated if the headquarter rises the contract’s incentive-based components. It is to say that moral hazard and asymmetric information underpin incentive compatible managerial compensation and the size of capital budget (Zhang, 1997).

The capital budget serves as the funding source for investment. It also serves as a “strategic device to control managerial shirking” (Zhang, 1997). Although, a huge budget size permits the company to invest in all profitable pr