Severe or gentle bankruptcy law : Which impact on investing and financing decisions ?

This research investigates how legal sanctions prevailing under bankruptcy may impact on debt contracting and on investing decision. We model firms having the opportunity to engage (or not) faulty management. In case of default, the firms may escape costly bankruptcy by reaching a private agreement with the bank. We show that such renegotiation process may depend on the level of severity of bankruptcy law. Our approach helps in answering the following key questions: can bankruptcy costs always be internalized? Who benefits from accrued severity? Should the creditors accept a certain level of moral hazard from their debtors? Should bankruptcy law be extremely severe in order to ensure ex-ante efficiency? Does such severity depend on the financial environment? The model focuses on three equilibriums. The first equilibrium describes honest firms that choose the best investment project (ex-ante efficiency). Here, we show that bankruptcy costs can be avoided through private renegotiation (ex-post efficiency). Yet, the legislator cannot directly implement this equilibrium as it does not depend on the level of legal sanctions. A second equilibrium describes tricky firms turning to the less profitable and riskiest project. Here, default is still privately resolved: the occurrence of such equilibrium can be avoided owing to a minimal amount of legal sanctions that depend on the level of interest rate. Last, we consider firms that adopt mixed strategies regarding their investment policy. Here, two post-default bargains prevail (pooling or separating) and costly bankruptcy may occur. Simulations illustrate how the bank finally chooses between these equilibriums while the legal environment becomes more severe. For moderate levels of legal sanctions, banks may accept a certain level of faulty management, expecting to take advantage of bankruptcy punishment. An increase in sanctions, however, has a compelling effect on the companies towards honoring their commitments. Once the optimal equilibrium prevails, any additional increase in sanctions is ineffective as the players' strategies no longer depend on the legal environment. As a result, extreme severity is not required to ensure both ex-ante and ex-post efficiencies. Last, we find that a more severe bankruptcy law increases the protection of banks and may result in reduction of the contractual interest rate, which on the other hand benefits the debtors.