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The role of collateral in a model of debt renegotiation

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  • Bester, H.

    (Tilburg University, School of Economics and Management)

Abstract

This paper studies the effect of debt renegotiation on the design of optimal loan arrangements in a model of borrowing and lending with asymmetric information. The optimal form of finance is a standard debt contract with a bankruptcy clause that acts as a payment incentive. Debt renegotiation may occur because bankruptcy involves costly asset liquidation which is ex post inefficient. We show that the extent of the entrepreneur's liabilities in the optimal loan contract depends upon the creditor's commitment to impose bankruptcy should default ever occur. If the creditor is precommitted not to forgive any portion of the outstanding debt, a limited liability arrangement is optimal. That is, default should entitle the creditor to liquidate only the assets remaining from the project that has been financed by the loan. In the absence of precommitment, however, the issuance of debt may efficiently be secured in addition by the entrepreneur's personal wealth outside the project.
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Suggested Citation

  • Bester, H., 1994. "The role of collateral in a model of debt renegotiation," Other publications TiSEM efe919a3-7b33-4c98-93d1-2, Tilburg University, School of Economics and Management.
    • Handle: RePEc:tiu:tiutis:efe919a3-7b33-4c98-93d1-294180b4b9e2
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    References listed on IDEAS

    as
    1. Oliver Hart & John Moore, 1998. "Default and Renegotiation: A Dynamic Model of Debt," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 113(1), pages 1-41.
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