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 Tilburg University, Center for Economic Research in its series Discussion Paper with number 1990-60.
Date of creation: 1990
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Web page: http://center.uvt.nl
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," Papers 9060, Tilburg - Center for Economic Research.
- Helmut Bester, 1990. "The Role of Collateral in a Model of Debt Renegotiation," CEPR Financial Markets Paper 0001, European Science Foundation Network in Financial Markets, c/o C.E.P.R, 77 Bastwick Street, London EC1V 3PZ.
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