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The Leverage Ratchet Effect

Author

Listed:
  • Anat R. Admati

    () (Graduate School of Business, Stanford University)

  • Peter M. DeMarzo

    () (Graduate School of Business, Stanford University)

  • Martin F. Hellwig

    () (Max Planck Institute for Research on Collective Goods)

  • Paul Pfleiderer

    () (Graduate School of Business, Stanford University)

Abstract

This paper explores the dynamics of corporate leverage when funding decisions are made in the interests of shareholders. In the absence of prior commitments or regulations, shareholder-creditor conflicts give rise to a leverage ratchet effect, which induces shareholders to resist reductions while favoring increases in leverage even when total-value maximization calls for the opposite. Unlike inefficiencies based on asymmetric information, the leverage ratchet effect applies to all forms of leverage reduction, including earnings retentions and rights offerings. The leverage ratchet effect is present even in the absence of frictions other than the inability to write complete contracts. The effect creates an agency cost of debt that lowers the value of the leveraged firm. Standard frictions magnify the impact of the effect. In a dynamic context, since leverage becomes effectively irreversible, firms may limit leverage initially but then ratchet it up in response to shocks. The resulting leverage dynamics can produce outcomes that cannot be explained by simple tradeoff considerations. Leverage can be adjusted in many ways. For example, leverage reductions can be achieved by issuing equity to either buy back debt or purchase new assets, or by selling assets to buy back debt. We study shareholders’ preferences over different ways to adjust leverage. A benchmark result gives conditions for shareholder indifference, but generally, shareholders have clear rankings over the alternatives. For example, shareholders often prefer reducing leverage by selling assets even at distressed prices.

Suggested Citation

  • Anat R. Admati & Peter M. DeMarzo & Martin F. Hellwig & Paul Pfleiderer, 2013. "The Leverage Ratchet Effect," Discussion Paper Series of the Max Planck Institute for Research on Collective Goods 2013_13, Max Planck Institute for Research on Collective Goods, revised Sep 2017.
  • Handle: RePEc:mpg:wpaper:2013_13
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    References listed on IDEAS

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    1. repec:oup:rcorpf:v:2:y:2013:i:1:p:29-61. is not listed on IDEAS
    2. Sudipto Bhattacharya & Kjell G. Nyborg, 2013. "Bank Bailout Menus," Review of Corporate Finance Studies, Oxford University Press, vol. 2(1), pages 29-61.
    3. Ilya A. Strebulaev & Baozhong Yang, 2012. "The Mystery of Zero-Leverage Firms," NBER Working Papers 17946, National Bureau of Economic Research, Inc.
    4. Myers, Stewart C. & Majluf, Nicolás S., 1945-, 1984. "Corporate financing and investment decisions when firms have information that investors do not have," Working papers 1523-84., Massachusetts Institute of Technology (MIT), Sloan School of Management.
    5. Kenneth French & Martin Baily & John Campbell & John Cochrane & Douglas Diamond & Darrell Duffie & Anil Kashyap & Frederic Mishkin & Raghuram Rajan & David Scharfstein & Robert Shiller & Hyun Song Shi, 2010. "The Squam Lake Report: Fixing the Financial System," Journal of Applied Corporate Finance, Morgan Stanley, vol. 22(3), pages 8-21.
      • Kenneth R. French & Martin N. Baily & John Y. Campbell & John H. Cochrane & Douglas W. Diamond & Darrell Duffie & Anil K Kashyap & Frederic S. Mishkin & Raghuram G. Rajan & David S. Scharfstein & Robe, 2010. "The Squam Lake Report: Fixing the Financial System," Economics Books, Princeton University Press, edition 1, number 9261.
    6. Gorton, Gary B., 2010. "Slapped by the Invisible Hand: The Panic of 2007," OUP Catalogue, Oxford University Press, number 9780199734153.
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    Blog mentions

    As found by EconAcademics.org, the blog aggregator for Economics research:
    1. A Primer on Bank Capital
      by Steve Cecchetti and Kim Schoenholtz in Money, Banking and Financial Markets on 2014-11-03 19:22:53

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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. 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.
    3. Lubberink, Martien, 2014. "Are banks’ below-par own debt repurchases a cause for prudential concern?," MPRA Paper 59475, University Library of Munich, Germany.
    4. 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.
    5. Claudio Albanese & Simone Caenazzo & St'ephane Cr'epey, 2016. "Capital Valuation Adjustment and Funding Valuation Adjustment," Papers 1603.03012, arXiv.org.
    6. Adrian, Tobias & Friedman, Evan & Muir, Tyler, 2015. "The cost of capital of the financial sector," Staff Reports 755, Federal Reserve Bank of New York.
    7. 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.
    8. 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.
    9. Zhiguo He & Konstantin Milbradt, 2016. "Dynamic Debt Maturity," NBER Working Papers 21919, National Bureau of Economic Research, Inc.
    10. Claudio Albanese & Simone Caenazzo & Stéphane Crépey, 2016. "Capital Valuation Adjustment and Funding Valuation Adjustment," Working Papers hal-01285363, HAL.
    11. repec:eee:jfinin:v:30:y:2017:i:c:p:86-106 is not listed on IDEAS
    12. 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.
    13. Lubberink, Martien, 2014. "A Primer on Regulatory Bank Capital Adjustments," MPRA Paper 55290, University Library of Munich, Germany.

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