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How Bankruptcy Punishment Influences the Ex-Ante Design of Debt Contracts?

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  • Régis Blazy

    ()
    (Luxembourg School of Finance, University of Luxembourg)

  • Gisèle Umbhauer

    ()

  • Laurent Weill

    ()

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    Abstract

    This research investigates how the legal sanctions prevailing under bankruptcy code impact on the design of debt contacts. Unlike most papers considering a passive behavior of the bank in case of default of the borrower, we assume the bank actively trades off between private renegotiation and costly bankruptcy procedure. Besides, the debtor’s investment policy – with a risk of asset substitution – and the creditor’s financial policy – endogenous interest rate – are explicitly modeled. The model focuses on three possible equilibriums. The first one encompasses situations where the firms stay with the best investment project (economic efficiency) and bankruptcy costs are avoided through private renegotiation (legal efficiency): this equilibrium requires a condition on bankruptcy costs and is independent of legal sanctions. A second equilibrium cover situations where the firms turn to the less profitable and riskiest project (economic inefficiency) and the default is still privately solved (legal efficiency): to avoid suboptimal investment, a minimal level of legal sanctions, whose threshold value depends on the interest rate, must apply. Last, we consider mixed strategies on the investment policy (partial economic efficiency): when financial distress occurs, two bargaining equilibriums prevail – pooling or separating – so costly bankruptcy may apply (legal inefficiency). Simulated results illustrate how the bank finally chooses between these equilibriums while the legal environment becomes more severe. First, as expected, when sanctions are getting higher, the probability of choosing the best project increases: simulations provide minimal levels of sanctions which guarantee the occurrence of the best equilibrium. As a result, extreme severity is not needed to ensure both economic and legal efficiency. Second, an increase of legal sanctions is likely to reduce the contractual interest rate, as the bank is more protected by the law, and cannot charge a risk premium anymore. A noteworthy consequence is that the debtor benefits in some extent of increased severity, as he is inclined to invest in the most profitable projects and, consequently, pays a lower interest rate. Third, a slight change of the legal environment may involve a drastic adjustment of financial variables, so that small changes in the law may involve financial instability.

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    Bibliographic Info

    Paper provided by Luxembourg School of Finance, University of Luxembourg in its series LSF Research Working Paper Series with number 08-04.

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    Date of creation: 2008
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    Handle: RePEc:crf:wpaper:08-04

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    Keywords: Bankruptcy; Credit Lending; Interest Rate; Moral Hazard; Legal Sanctions;

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    1. Kolecek, Ludek, 2008. "Bankruptcy laws and debt renegotiation," Journal of Financial Stability, Elsevier, vol. 4(1), pages 40-61, April.
    2. Rafael La Porta & Florencio Lopez-de-Silane & Andrei Shleifer & Robert W. Vishny, 1997. "Legal Determinants of External Finance," NBER Working Papers 5879, National Bureau of Economic Research, Inc.
    3. Gilson, Stuart C, 1997. " Transactions Costs and Capital Structure Choice: Evidence from Financially Distressed Firms," Journal of Finance, American Finance Association, vol. 52(1), pages 161-96, March.
    4. Harris, Milton & Raviv, Artur, 1990. " Capital Structure and the Informational Role of Debt," Journal of Finance, American Finance Association, vol. 45(2), pages 321-49, June.
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    9. Cornelli, Francesca & Felli, Leonardo, 1997. "Ex-ante efficiency of bankruptcy procedures," European Economic Review, Elsevier, vol. 41(3-5), pages 475-485, April.
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    12. Gorton, Gary & Kahn, James, 2000. "The Design of Bank Loan Contracts," Review of Financial Studies, Society for Financial Studies, vol. 13(2), pages 331-64.
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    14. Bebchuk, Lucian Arye, 2000. "Using options to divide value in corporate bankruptcy," European Economic Review, Elsevier, vol. 44(4-6), pages 829-843, May.
    15. Blazy, Regis & Chopard, Bertrand, 2004. "Ex post efficiency of bankruptcy procedures: A general normative framework," International Review of Law and Economics, Elsevier, vol. 24(4), pages 447-471, December.
    16. Bester, Helmut, 1985. "Screening vs. Rationing in Credit Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 75(4), pages 850-55, September.
    17. S. Baranzoni & P. Bianchi & L. Lambertini, 2000. "Market Structure," Working Papers 368, Dipartimento Scienze Economiche, Universita' di Bologna.
    18. White, Michelle J, 1989. "The Corporate Bankruptcy Decision," Journal of Economic Perspectives, American Economic Association, vol. 3(2), pages 129-51, Spring.
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