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

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.