[Show abstract][Hide abstract] ABSTRACT: How should loan contracts to finance projects in countries with high political risk be designed? We develop a double moral hazard model in which the bank’s incentive to mitigate political risk is highest with a non-recourse project finance loan, while for the firm’s incentive to manage operational risk it is best to have a full-recourse loan. We predict that the use of project finance increases with both the political risk of the country in which the project is located and the lender’s influence over this political risk exposure. Furthermore, the use of project finance should decrease as the economic health and corporate governance provisions of the borrower’s home country improve. We test these predictions with a sample of 4,549 loans made to borrowers in 90 countries. We find overall support for our model and provide evidence that multi-lateral development banks indeed represent a “political umbrella”.
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