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Creditor Conflicts prior to Bankruptcy and Credit Rationing

Berkeley Electronic Press
Publication Date
  • Economics


In this paper we focus on conflicts of interest between senior and junior debt which occur prior to bankruptcy. When coalitions between the entrepreneur and one creditor are possible and the coalition has private information, a special kind of agency problem may arise. The entrepreneur and one creditor could cooperate and change investment policy jointly, at the cost of the remaining creditor. This may even work, when asset substitution is not efficient. In principle, there are two kinds of coalition problems. The coalition comprised of the entrepreneur and the junior creditor tends to favor risk-increasing, a coalition involving the senior creditor favors risk-decreasing. Adopting the formal framework of Stiglitz/Weiss (1981) and Bester/Hellwig (1987), we analyze a risk-decreasing coalition problem. The entrepreneur and the senior creditor form the coalition and behave opportunistically. The junior creditor may anticipate this problem and then rations credit supply. If the junior creditor can seize some private wealth from the entrepreneur (external collateral), the problem is mitigated. The coalition problem depends on the type of senior and junior debt. When there is a me-first-rule or when there is unsecured and subordinated debt, coalition problems may be more severe than in the case of secured and unsecured debt. When the senior claim is completely backed by collateral, e.g. by mortgages, the senior creditor doesn't have an incentive for coalition. If it's not fully backed and the value of secured claims depends on investment policy, e.g. in the case of blanket assignments of receivables, there may be a coalition problem.

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