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The Leverage Ratchet Effect

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  • Admati, Anat R.

    (Stanford University)

  • DeMarzo, Peter M.

    (Stanford University)

  • Hellwig, Martin F.

    (Max Planck Institute for Research on Collective Goods)

  • Pfleiderer, Paul

    (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.

Suggested Citation

  • Admati, Anat R. & DeMarzo, Peter M. & Hellwig, Martin F. & Pfleiderer, Paul, 2013. "The Leverage Ratchet Effect," Research Papers 3029, Stanford University, Graduate School of Business.
  • Handle: RePEc:ecl:stabus:3029
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    File URL: http://www.gsb.stanford.edu/faculty-research/working-papers/leverage-ratchet-effect
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    Cited by:

    1. Bahaj, Saleem & Bridges, Jonathan & Malherbe, Frederic & O’Neill, Cian, 2016. "What determines how banks respond to changes in capital requirements?," Bank of England working papers 593, Bank of England.
    2. Claudio Albanese & Simone Caenazzo & Stéphane Crépey, 2016. "Capital Valuation Adjustment and Funding Valuation Adjustment," Working Papers hal-01285363, HAL.
    3. Heider, Florian & Ljungqvist, Alexander, 2015. "As certain as debt and taxes: Estimating the tax sensitivity of leverage from state tax changes," Journal of Financial Economics, Elsevier, vol. 118(3), pages 684-712.
    4. repec:eee:jfinec:v:129:y:2018:i:3:p:510-530 is not listed on IDEAS
    5. Lubberink, Martien, 2014. "Are banks’ below-par own debt repurchases a cause for prudential concern?," MPRA Paper 59475, University Library of Munich, Germany.
    6. Lucy M. Goodhart, 2015. "Brave New World? Macro-prudential policy and the new political economy of the federal reserve," Review of International Political Economy, Taylor & Francis Journals, vol. 22(2), pages 280-310, April.
    7. Claudio Albanese & Simone Caenazzo & St'ephane Cr'epey, 2016. "Capital Valuation Adjustment and Funding Valuation Adjustment," Papers 1603.03012, arXiv.org.
    8. Hugonnier, Julien & Malamud, Semyon & Morellec, Erwan, 2015. "Credit market frictions and capital structure dynamics," Journal of Economic Theory, Elsevier, vol. 157(C), pages 1130-1158.
    9. Gormley, Todd A. & Matsa, David A., 2016. "Playing it safe? Managerial preferences, risk, and agency conflicts," Journal of Financial Economics, Elsevier, vol. 122(3), pages 431-455.
    10. Anat R. Admati & Peter M. DeMarzo & Martin F. Hellwig & Paul Pfleiderer, 2013. "Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Socially Expensive," Discussion Paper Series of the Max Planck Institute for Research on Collective Goods 2013_23, Max Planck Institute for Research on Collective Goods.
    11. Lubberink, Martien, 2014. "A Primer on Regulatory Bank Capital Adjustments," MPRA Paper 55290, University Library of Munich, Germany.

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