Bankruptcy in Credit Chains
When ﬁrms use bank oans and trade credit,bankruptcy rules can magnify aggregate ﬂuctuations.A priori,a rule where banks are senior is not appropriate to dampen ﬂuctuations.It might force trade creditors into bankruptcy by triggering a ‘domino e ﬀect ’-when ﬁrms go bust because their clients default.Yet,banks are often senior.In this paper,we characterize the conditions under which such a rule limits the likelihood of bankruptcies.We model a credit chain where in equilibrium ﬁrms use trade credit and bank loans.Due to the credit chain,bank seniority minimizes the overall risk premium charged by trade creditors and banks.Although bank seniority magni ﬁes the domino e ﬀect,we ﬁnd it is optimal whenever there is a relatively high proportion of bad risks
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