Soft Budget Constraint and Stock Price Information

Publication Date
Financial Markets Group Discussion Papers DP 251
Publication Authors

This article investigates the ability of regulatory agencies to keep firms to fixed budgets. The budget implemented at an interim date is always superior to the one efficient ex ante, since, at the interim stage, regulators do not internalize the disincentive effect of their intervention on firm's effort. Budget constraints are more or less soft according to the information available to regulators. The ability of financial markets to generate information is endogenized. It is shown that stock price information may increase the softness of the budget constraint, decrease firms' incentives to exert effort and may reduce social welfare. It also appears that the "softness" of these constraints depends on the type of claims used to finance initial investments. A straightforward application of the model sheds light on the privatisation decision.