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Leverage and Risk Taking

We study a dynamic contracting problem in which size is relevant. The agent may take on excessive risk to enhance short-term gains, which exposes the principal to large, infrequent losses. To preserve incentive compatibility, the optimal contract uses size as an instrument; there is downsizing on the equilibrium path. The contract may be implemented using the full array of financial securities or as a regulation contract with a leverage ratio. We show that holding equity is essential to curb risk taking. Firms that are less prone to risk taking can afford a higher leverage.