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Bankruptcy Priority for Bank Deposits: a Contract Theoretic Explanation

Over the past decade several countries, including the US, have introduced or redesigned legislation that confers priority in bankruptcy upon all or some bank deposits. We argue that in the presence of contracting costs such rules can increase efficiency. We first show in a private information model that a borrower can reduce overall costs of finance by letting informationally heterogeneous lenders choose between junior and senior debt. In particular, we find that debt priorities reduce socially wasteful information gathering by investors. We then argue why, particularly in banking, legal standardization of debt priorities may be superior to bilateral private arrangements.

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Paper provided by Swiss National Bank, Study Center Gerzensee in its series Working Papers with number 00.01.

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Length: 51 pages
Date of creation: Nov 1999
Date of revision:
Publication status: Forthcoming in Review of Financial Studies.
Handle: RePEc:szg:worpap:0001
Contact details of provider: Postal: Studienzentrum Gerzensee, Postfach 21, 3115 Gerzensee
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  1. Sussman, Oren, 1999. "Economic growth with standardized contracts," European Economic Review, Elsevier, vol. 43(9), pages 1797-1818, October.
  2. Repullo, R. & Suarez, J., 1996. "Monitoring, Liquidation, and Security Design," Papers 273, Banca Italia - Servizio di Studi.
  3. Hart, Oliver & Moore, John, 1995. "Debt and Seniority: An Analysis of the Role of Hard Claims in Constraining Management," American Economic Review, American Economic Association, vol. 85(3), pages 567-85, June.
  4. Gorton, G. & Khan, J., 1992. "The Design of Bank Loan Contracts, Collateral, and Renegociation," RCER Working Papers 327, University of Rochester - Center for Economic Research (RCER).
  5. Mathias Dewatripont & Jean Tirole, 1994. "The prudential regulation of banks," ULB Institutional Repository 2013/9539, ULB -- Universite Libre de Bruxelles.
  6. Barclay, Michael J & Smith, Clifford W, Jr, 1995. " The Priority Structure of Corporate Liabilities," Journal of Finance, American Finance Association, vol. 50(3), pages 899-917, July.
  7. Scott, James H, Jr, 1977. "Bankruptcy, Secured Debt, and Optimal Capital Structure," Journal of Finance, American Finance Association, vol. 32(1), pages 1-19, March.
  8. Arthur B. Kennickell & Myron L. Kwast & Martha Starr-McCluer, 1995. "Households' deposit insurance coverage: evidence and analysis of potential reforms," Finance and Economics Discussion Series 95-5, Board of Governors of the Federal Reserve System (U.S.).
  9. Calomiris, Charles W & Kahn, Charles M, 1991. "The Role of Demandable Debt in Structuring Optimal Banking Arrangements," American Economic Review, American Economic Association, vol. 81(3), pages 497-513, June.
  10. William P. Osterberg, 1996. "The impact of depositor preference laws," Economic Review, Federal Reserve Bank of Cleveland, issue Q III, pages 2-11.
  11. Calomiris, Charles W., 1999. "Building an incentive-compatible safety net," Journal of Banking & Finance, Elsevier, vol. 23(10), pages 1499-1519, October.
  12. Winton, Andrew, 1995. "Costly State Verification and Multiple Investors: The Role of Seniority," Review of Financial Studies, Society for Financial Studies, vol. 8(1), pages 91-123.
  13. Diamond, Douglas W., 1993. "Seniority and maturity of debt contracts," Journal of Financial Economics, Elsevier, vol. 33(3), pages 341-368, June.
  14. Douglas D. Evanoff, 1992. "Preferred sources of market discipline: depositors vs. subordinated debt holders," Working Paper Series, Issues in Financial Regulation 92-21, Federal Reserve Bank of Chicago.
  15. Stulz, ReneM. & Johnson, Herb, 1985. "An analysis of secured debt," Journal of Financial Economics, Elsevier, vol. 14(4), pages 501-521, December.
  16. Fama, Eugene F., 1985. "What's different about banks?," Journal of Monetary Economics, Elsevier, vol. 15(1), pages 29-39, January.
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