What are some possible agency conflicts between borrowers and lenders?


What are some possible agency conflicts between borrowers and lenders?

Answer and ExplanationSolution by a verified expert


Lenders always examine the utilisation of funds before releasing the funds. Consider a scenario where a financial institution has provided a loan to a company by assets the credibility of business and its assets. However, after the funds are borrowed, the company sells its existing assets and invests the proceeds along with the funds borrowed in other projects. According to the company the new project provides high profitability in the long run though it has a high risk element.
The financial institution may object to this. If the investment fails, and the company is in the position of bankruptcy, the financial institution will suffer from bad debts. Even if the investment is successful. The company can get benefits of higher profitability and the financial institution will get its fixed interest income. Thus, there is no reward to the lender for the risk taken by the borrower in this case.
Thus, there occurs conflict between the lenders and borrowers if the utilisation of the funds is against the lender's interest.

Verified Answer

Agency conflicts can arise between the borrowers and the lenders when the borrowers invests the borrowed funds in the high risk projects. Such an investment may not be liked by the lenders as it would lead them to losses on failure of investment.

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