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The Impact of Legal Sanctions on Moral Hazard when Debt Contracts are Renegotiable

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Author Info
Régis Blazy () (CREFI-LSF, Luxembourg University, Luxembourg School of Finance, Luxembourg.)
Laurent Weill () (LARGE, Université Robert Schuman, Institut d'Etudes Politiques, France and Centre Emile Bernheim, Solvay Business School, Université Libre de Bruxelles, Brussels.)

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Abstract

This research investigates how bankruptcy law influences the design of debt contracts and the investment choice through the sanction of faulty managers. We model a lending relationship between a small firm and a monopolistic bank which decides the loan rate. The firm may perform asset substitution, which is punished by the Law through legal sanctions. These sanctions are implemented in case of costly bankruptcy only. This way of resolving financial distress can be avoided yet, if a private agreement is achieved. First, – when sanctions are high – we show that costly bankruptcy may be preferred by honest firms over private negotiation. Thus costly bankruptcy cannot be avoided under a severe legal environment. However, as the bank internalizes the rules of default, debt contracts are designed so that this situation never happens at equilibrium (“legal efficiency”).Second, a peculiar legislation may incite banks to accept generalized moral hazard (“economic inefficiency”). Then, the legislator can indectly enforce economic efficiency. However he must consider effects beyond the simple comparison between legal sanctions and bankruptcy costs, and focus on the impact of such legal sanctions on the design of the debt contract. Simulated results show that even small changes of legal sanctions may have drastic effects on the firm’s investment policy. Besides, it appears that extreme severity (i.e. 100% of the manager’s wealth is subject to legal sanctions) is not needed to ensure economic efficiency. Last, in some cases, the legislator may have the choice between several levels of legal sanctions all leading to economic efficiency: when choosing between them, the legislator affects the profit sharing only.

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Publisher Info
Paper provided by Université Libre de Bruxelles, Solvay Business School, Centre Emile Bernheim (CEB) in its series Working Papers CEB with number 07-012.RS.

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Length: 41 pages
Date of creation: May 2007
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Handle: RePEc:sol:wpaper:07-012

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Related research
Keywords: Bankruptcy Credit Lending Moral Hazard Sanctions

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Find related papers by JEL classification:
G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information
D21 - Microeconomics - - Production and Organizations - - - Firm Behavior

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Full references

Cited by:
(explanations, Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.)

  1. Pierre-Guillaume Méon & Friedrich Schneider & Laurent Weill, 2007. "Does taking the shadow economy into account matter to measure aggregate efficiency?," Working Papers DULBEA 07-18.RS, Université libre de Bruxelles, Department of Applied Economics (DULBEA). [Downloadable!]
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  2. Olga Bourachnikova, 2007. "Weighting Function in the Behavioral Portfolio Theory," Working Papers DULBEA 07-07.RS, Université libre de Bruxelles, Department of Applied Economics (DULBEA). [Downloadable!]
  3. Henri Capron, 2007. "Politique de cohésion et développement régional," Working Papers DULBEA 07-16.RS, Université libre de Bruxelles, Department of Applied Economics (DULBEA). [Downloadable!]
  4. Ariane Szafarz, 2007. "Hiring People-like-Yourself: A Representation of Discrimination on the Job Market," Working Papers DULBEA 07-21.RS, Université libre de Bruxelles, Department of Applied Economics (DULBEA). [Downloadable!]
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  5. Henri Capron & Michele Cincera, 2007. "EU Pre-competitive and Near-the-Market S&T Collaborations," Working Papers DULBEA 07-17.RS, Université libre de Bruxelles, Department of Applied Economics (DULBEA). [Downloadable!]
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  6. Jean-Luc De Meulemeester, 2007. "L'Economie de l'Education fait-elle des Progrès? Une Perspective d'Histoire de la Pensée Economique," Working Papers DULBEA 07-15.RS, Université libre de Bruxelles, Department of Applied Economics (DULBEA). [Downloadable!]
  7. Jérôme de Henau & Leila Maron & Danièle Meulders, 2007. "Travail et Maternité en Europe, COnditions de Travail et Politiques Publiques," Working Papers DULBEA 07-14.RS, Université libre de Bruxelles, Department of Applied Economics (DULBEA). [Downloadable!]
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