Reputation concerns deter opportunistic behavior by creating a link between past actions and expectations about future actions. Consider, for example, an environment in which lenders provide funds to firms whose risk-taking decisions and profits are unobservable. Firms could take excessive risk, appropriating most of the benefits from large successes and imposing most of the losses from big failures on lenders. This inefficient risk-taking reduces lending and increases its cost. However, if firms generate signals correlated to decisions, lenders could use those signals to construct reputation and offer better lending conditions to firms with better reputation. Firms are then afraid of losing their reputation and are deterred from taking excessive risk. This role for reputation has been extensively discussed in the literature.
The point of this paper is to argue that these reputational incentives are fragile because they may suddenly collapse, inducing big changes in aggregate risk-taking in response to small changes in aggregate fundamentals. This sudden shift in behavior may have a large impact on economic outcomes such as corporate failures, credit conditions, interest rates, and returns to investors. Hence reputation may have been an unnoticed detonator of financial collapses and credit crunches characterized by confidence crises. In normal times, lenders have confidence in firms with good reputation and no confidence in firms with bad reputation. In bad times, lenders lose confidence in almost all firms and lending breaks down.
I construct a model where incentives to take risk monotonically vary with a stochastic aggregate fundamental. All firms can invest in risky projects and some of them (strategic firms) can also invest in safer projects, with a lower probability of default and a higher probability of generating good signals. A firm’s reputation is defined as the probability that lenders assign to the firm being the strategic type. Reputation is Bayesian updated by lenders from observing the signals, and firm incentives are shaped in large part by the concern for their reputation. To protect their reputation, strategic firms engage in safe projects when otherwise they would have preferred to opportunistically take risky ones.
In the absence of any equilibrium selection device, it is not possible to draw firm conclusions about the interplay between reputation and risk-taking, since this model delivers multiple equilibria. For some range of fundamentals, if lenders believe that strategic firms will play safe, then these firms will indeed have incentives to play safe to increase the probability of good signals. The reason is that good signals will be in part attributed to the firm using a safe project and then the firm being strategic. Contrarily, if lenders believe that strategic firms will undergo risky projects, then firms will indeed have incentives to take risks. In this case, good signals will be just attributed to good luck in risky projects. This strong dependence of reputation formation on lenders beliefs about firms choices is at the heart of the reputation fragility. It is irrelevant whether or not a firm has a good reputation if lenders are convinced the firm will choose the risky project.
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Fragility of Reputation and Clustering in Risk-Taking
