riskshifting

Risk shifting is a term used in finance and contract theory to describe the transfer or reshaping of risk exposure among parties through financial arrangements or incentives. In corporate finance, it refers to the tendency of managers to alter a firm’s risk profile after external funds have been raised, often in ways that benefit equity holders at the expense of debt holders or other creditors. A common manifestation is the asset substitution problem, where debt-financed firms pursue riskier projects because the upside benefits equity holders while the downside falls on creditors.

The mechanism relies on asymmetric information and incomplete contracts. When a firm is levered, managers may have more to gain from high-risk, high-return projects, since successful outcomes disproportionately reward equity while losses are borne mainly by debt holders. Since debt has limited liability for equity holders, the contract cannot perfectly constrain investments, creating an incentive to shift risk after financing. Market participants counteract risk shifting with protective covenants, collateral requirements, seniority provisions, or monitoring, which align incentives and limit the scope for risky asset substitutions.

The effects of risk shifting can reduce the value of debt and increase agency costs if managerial incentives diverge from creditors’ interests. Empirical evidence on risk shifting is context-dependent and mixed, varying with firm leverage, contract design, and market conditions. Some studies document increased risk-taking around debt issuance or near financial distress, while others find weaker or transient effects.

See also: asset substitution, moral hazard, agency theory, debt covenants.