The Role of Collateral in a Model of Debt Renegotiation
AbstractThis paper studies the effect of debt renegotiation on the design of optimal loan arrangements in a model of borrowing and lending with asymmetric information. The optimal form of finance is a standard debt contract with a bankruptcy clause that acts as a payment incentive. Debt renegotiation may occur because bankruptcy involves costly asset liquidation which is ex post inefficient. We show that the extent of the entrepreneur's liabilities in the optimal loan contract depends upon the creditor's commitment to impose bankruptcy should default ever occur. If the creditor is precommitted not to forgive any portion of the outstanding debt, a limited liability arrangement is optimal. That is, default should entitle the creditor to liquidate only the assets remaining from the project that has been financed by the loan. In the absence of precommitment, however, the issuance of debt may efficiently be secured in addition by the entrepreneur's personal wealth outside the project.
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Bibliographic InfoPaper provided by European Science Foundation Network in Financial Markets, c/o C.E.P.R, 77 Bastwick Street, London EC1V 3PZ in its series CEPR Financial Markets Paper with number 0001.
Date of creation: Sep 1990
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Other versions of this item:
- Bester, Helmut, 1994. "The Role of Collateral in a Model of Debt Renegotiation," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 26(1), pages 72-86, February.
- Bester, H., 1990. "The Role of Collateral in a Model of Debt Renegotiation," Discussion Paper 1990-60, Tilburg University, Center for Economic Research.
- Bester, H., 1990. "The Role Of Collateral In A Model Of Debt Renegotiation," Papers 9060, Tilburg - Center for Economic Research.
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- Huberman, Gur & Kahn, Charles M., 1988. "Strategic renegotiation," Economics Letters, Elsevier, vol. 28(2), pages 117-121.
- Mookherjee, Dilip & Png, Ivan, 1989. "Optimal Auditing, Insurance, and Redistribution," The Quarterly Journal of Economics, MIT Press, vol. 104(2), pages 399-415, May.
- Schwartz, Alan., . "Security Interests and Bankruptcy Priorities: A Review of Current Theories," Working Papers 334, California Institute of Technology, Division of the Humanities and Social Sciences.
- Benjamin, Daniel K, 1978. "The Use of Collateral to Enforce Debt Contracts," Economic Inquiry, Western Economic Association International, vol. 16(3), pages 333-59, July.
- de Meza, David & Webb, David C, 1987. "Too Much Investment: A Problem of Asymmetric Information," The Quarterly Journal of Economics, MIT Press, vol. 102(2), pages 281-92, May.
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