In monetary economics it is argued that due to agency cost in financial contracting a reduction of a firm's net worth will transmit into a decline of investment. This paper shows that the microeconomic foundation of this 'balance-sheet-channel' is dubious. Contrary to a common claim agency problems in financial contracting do not generate underinvestment by virtue of their impact on the shadow cost of external funds. Firms with low net worth, hence high cost of external financing, might even overinvest. Agency problems, however,do generate a more subtile balance sheet eÿect. The dependence on uncollateralized external funding impairs the ability to accept business risk. This may explain, why during major economic downturns firms and banks shun risks that could be accepted in better times.
D82 - Asymmetric and Private Information ; E44 - Financial Markets and the Macroeconomy ; G3 - Corporate Finance and Governance ; Financial theory ; Bookkeeping and balancing of an account ; Individual Working Papers, Preprints ; No country specification