2. Consider a lender-borrower relationship under moral hazard. The risk-neutral borrower wants to borrow an amount I from a lender (a bank) to finance a project with safe return V. The project, with probability 1 - e, may harm a third-party (environment). The amount of safety care e costs efe) to the borrower with v, > 0,e" > 0 and "' > 0, The harm is an amount equal to h. A financial contract is a pair (t.t) where t is the borrower's reimbursement to the bank if there is no environmental damage, and i is the borrower's reimbursement to the bank if there is environmental damage h (a) Suppose that e is observable. Compute the first-best level of safety care and assume that the project is socially valuable when the interest rate is r (b) Suppose now that e is not observable. Assuming that the bank is competitive (zero- profit) and that the borrower has sufficient liability, show that the first-best is still implementable if the bank must reimburse h to the third-party in case of an accident. (c) Suppose that the bank must reimburse c0. Lea CARA von (a) When e is not observable, compute the optimal contract with a risk-neutral agent (b) When the agent is protected by limited liability, compute the second-best effort. (c) Analyze the two limiting cases where the principal is infinitely risk-averse (po) and where he is risk-neutral (p 0) 2. Consider a lender-borrower relationship under moral hazard. The risk-neutral borrower wants to borrow an amount I from a lender (a bank) to finance a project with safe return V. The project, with probability 1 - e, may harm a third-party (environment). The amount of safety care e costs efe) to the borrower with v, > 0,e" > 0 and "' > 0, The harm is an amount equal to h. A financial contract is a pair (t.t) where t is the borrower's reimbursement to the bank if there is no environmental damage, and i is the borrower's reimbursement to the bank if there is environmental damage h (a) Suppose that e is observable. Compute the first-best level of safety care and assume that the project is socially valuable when the interest rate is r (b) Suppose now that e is not observable. Assuming that the bank is competitive (zero- profit) and that the borrower has sufficient liability, show that the first-best is still implementable if the bank must reimburse h to the third-party in case of an accident. (c) Suppose that the bank must reimburse c0. Lea CARA von (a) When e is not observable, compute the optimal contract with a risk-neutral agent (b) When the agent is protected by limited liability, compute the second-best effort. (c) Analyze the two limiting cases where the principal is infinitely risk-averse (po) and where he is risk-neutral (p 0)