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The Role of Collateral in a Model of Debt Renegotiation

  • Helmut Bester

This 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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Paper 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.

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Date of creation: Sep 1990
Date of revision:
Availability: in print
Handle: RePEc:cpr:ceprfm:0001
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References listed on IDEAS
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  1. Leeth, John D. & Scott, Jonathan A., 1989. "The Incidence of Secured Debt: Evidence from the Small Business Community," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 24(03), pages 379-394, September.
  2. Fernandez, R. & Rosenthal, R.W., 1988. "Sovereign-Debt Renegotiations: A Strtegic Analysis," Papers 85, Boston University - Center for Latin American Development Studies.
  3. Oliver Hart & John Moore, 1997. "Default and Renegotiation: A Dynamic Model of Debt," STICERD - Theoretical Economics Paper Series 321, Suntory and Toyota International Centres for Economics and Related Disciplines, LSE.
  4. Jeremy I. Bulow & Kenneth Rogoff, 1986. "A Constant Recontracting Model of Sovereign Debt," NBER Working Papers 2088, National Bureau of Economic Research, Inc.
  5. Mathias Dewatripont, 1989. "Renegotiation and information revelation over time: the case of optimal labor contacts," ULB Institutional Repository 2013/9573, ULB -- Universite Libre de Bruxelles.
  6. repec:tpr:qjecon:v:102:y:1987:i:2:p:281-92 is not listed on IDEAS
  7. Hart, Oliver D & Tirole, Jean, 1988. "Contract Renegotiation and Coasian Dynamics," Review of Economic Studies, Wiley Blackwell, vol. 55(4), pages 509-40, October.
  8. Diamond, Douglas W, 1984. "Financial Intermediation and Delegated Monitoring," Review of Economic Studies, Wiley Blackwell, vol. 51(3), pages 393-414, July.
  9. 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.
  10. Jean-Jacques Laffont & Jean Tirole, 1985. "The Dynamics of Incentive Contracts," Working papers 397, Massachusetts Institute of Technology (MIT), Department of Economics.
  11. Barro, Robert J, 1976. "The Loan Market, Collateral, and Rates of Interest," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 8(4), pages 439-56, November.
  12. Besanko, David & Thakor, Anjan V, 1987. "Collateral and Rationing: Sorting Equilibria in Monopolistic and Competitive Credit Markets," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 28(3), pages 671-89, October.
  13. Bester, Helmut, 1987. "The role of collateral in credit markets with imperfect information," European Economic Review, Elsevier, vol. 31(4), pages 887-899, June.
  14. Gale, Douglas & Hellwig, Martin, 1989. "Repudiation and Renegotiation: The Case of Sovereign Debt," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 30(1), pages 3-31, February.
  15. repec:tpr:qjecon:v:104:y:1989:i:2:p:399-415 is not listed on IDEAS
  16. Gale, Douglas & Hellwig, Martin, 1985. "Incentive-Compatible Debt Contracts: The One-Period Problem," Review of Economic Studies, Wiley Blackwell, vol. 52(4), pages 647-63, October.
  17. 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.
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