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The Leverage Ratchet Effect

Author

Listed:
  • 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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