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The Leverage Ratchet Effect

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  • Anat R. Admati

    ()
    (Graduate School of Business, Stanford University)

  • Peter M. DeMarzo

    ()
    (Graduate School of Business, Stanford University)

  • Martin F. Hellwig

    ()
    (Max Planck Institute for Research on Collective Goods)

  • Paul Pfleiderer

    ()
    (Graduate School of Business, Stanford University)

Abstract

Shareholder-creditor conflicts can create leverage ratchet effects, resulting in inefficient capital structures. Once debt is in place, shareholders may inefficiently increase leverage but avoid reducing it no matter how beneficial leverage reduction might be to total firm value. We present conditions for an irrelevance result under which shareholders view asset sales, pure recapitalization and asset expansion with new equity as equally undesirable. We then analyze how seniority, asset heterogeneity, and asymmetric information affect shareholders’ choice of leverage-reduction method. Our results are particularly relevant to banking and highlight the benefit and importance of capital regulation to constrain inefficient excessive borrowing.

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Bibliographic Info

Paper provided by Max Planck Institute for Research on Collective Goods in its series Working Paper Series of the Max Planck Institute for Research on Collective Goods with number 2013_13.

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Date of creation: Aug 2013
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Handle: RePEc:mpg:wpaper:2013_13

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  1. Sudipto Bhattacharya & Kjell G. Nyborg, 2011. "Bank Bailout Menus," FMG Discussion Papers dp668, Financial Markets Group.
  2. Kenneth French & Martin Baily & John Campbell & John Cochrane & Douglas Diamond & Darrell Duffie & Anil Kashyap & Frederic Mishkin & Raghuram Rajan & David Scharfstein & Robert Shiller & Hyun Song Shi, 2010. "The Squam Lake Report: Fixing the Financial System," Journal of Applied Corporate Finance, Morgan Stanley, vol. 22(3), pages 8-21.
  3. Gorton, Gary B., 2010. "Slapped by the Invisible Hand: The Panic of 2007," OUP Catalogue, Oxford University Press, number 9780199734153, September.
  4. Myers, Stewart C. & Majluf, Nicolás S., 1945-, 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Working papers 1523-84., Massachusetts Institute of Technology (MIT), Sloan School of Management.
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