Reputation, Renegotiation, and the Choice between Bank Loans and Publicly Traded Debt

Abstract

We model firms' choice between bank loans and publicly traded debt, allowing for debt renegotiation in the event of financial distress. Entrepreneurs, with private information about their probability of financial distress, borrow from banks (multiperiod players) or issue bonds to implement projects. If a firm is in financial distress, lenders devote a certain amount of resources (unobservable to entrepreneurs) to evaluate whether to liquidate the firm or to renegotiate its debt. We demonstrate that banks' desire to acquire a reputation for making the "right" renegotiation versus liquidation decision provides them an endogenous incentive to devote a larger amount of resources than bondholders toward such evaluations. In equilibrium, bank loans dominate bonds from the point of view of minimixing inefficient liquidation; however, firms with a lower probability of financial distress choose bonds over bank loans.

The role of bank lending tightening on corporate bond issuance in the eurozone

“…One concern might be that the economic downturn induced an expansion in the demand for bonds. Previous frontier literature (Diamond (1991), Rajan (1992), Chemmanur and Fulghieri (1994) and Bolton and Freixas (2000)) documents that the preference for bank debt is due to the monitoring advantage of banks, whereas public debt is more readily available for projects with better 1 It is argued multiple-currency issue is one source of market segmentation. Other frictions exist such as di¤erences in tax treatment, business conventions, issuance policy, security trading and settlement systems, and availability of information (Pagano and von Thadden (2004) Corporate banking pro…tability was severely hit and challenged by the bursting of asset-bubbles during the 2007-2009 episode.…”

Reinsurance or securitization: The case of natural catastrophe risk

“…Examples of such papers are Bolton and Freixas (2000), Boot and Thakor (1997), Chemmanur and Fulghieri (1994), and Subrahmanyam and Titman (1999). In many of these papers, the basic problems are those of moral hazard and adverse selection.…”

Random monitoring in financing relationships

“…Relative to the payo¤ given by equation (9), the percentage increase in pro…ts can thus be calculated as:…”

“…The usefulness of identifying entrepreneurs at the beginning of a relationship is particularly important 1 Diamond (1984), and Fama (1985), among others, argue that banks have scale economies and comparative cost advantages over other lenders in producing information about the borrowers. Others, such as Chemmanur and Fulghieri (1994) attribute the monitoring ability of banks to their incentives to build their reputation as lenders. The literature on banks' incentives to monitor includes Winton (1993), Holmstrom and Tirole (1997) and Carletti (2004).…”

“…9 In the standard model, a court costlessly enforces only the aspects of the contract that it can verify. Benrhardt and Nosal (2004) present a model where the court makes errors and the parties prefer to renegotiate the original contract to eliminate ex post ine¢ ciencies.…”