Abstract

http://ssrn.com/abstract=2304969
 
 

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The Leverage Ratchet Effect


Anat R. Admati


Stanford Graduate School of Business

Peter M. DeMarzo


Stanford Graduate School of Business; National Bureau of Economic Research (NBER)

Martin F. Hellwig


Max Planck Institute for Research on Collective Goods; University of Bonn - Department of Economics

Paul C. Pfleiderer


Stanford Graduate School of Business

July 31, 2013

Rock Center for Corporate Governance at Stanford University Working Paper No. 146
Preprints of the Max Planck Institute for Research on Collective Goods Bonn 2013/13

Abstract:     
Shareholder-creditor conflicts can create leverage ratchet effects, resulting in inefficient capital structures. Once debt is in place, shareholders may inefficiently increase leverage but avoid reducing it no matter how beneficial leverage reduction might be to total firm value.

We present conditions for an irrelevance result under which shareholders view asset sales, pure recapitalization and asset expansion with new equity as equally undesirable. We then analyze how seniority, asset heterogeneity, and asymmetric information affect shareholders’ choice of leverage-reduction method.

Our results are particularly relevant to banking and highlight the benefit and importance of capital regulation to constrain inefficient excessive borrowing.

Number of Pages in PDF File: 61

Keywords: capital regulation, financial institutions, capital structure, too big to fail, systemic risk, bank equity, debt overhang, under-investment, recapitalization, deleveraging, bankruptcy costs, Basel

JEL Classification: G21, G28, G32, G38, H81, K23

working papers series


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Date posted: August 2, 2013 ; Last revised: October 24, 2013

Suggested Citation

Admati, Anat R. and DeMarzo, Peter M. and Hellwig, Martin F. and Pfleiderer, Paul C., The Leverage Ratchet Effect (July 31, 2013). Preprints of the Max Planck Institute for Research on Collective Goods Bonn 2013/13. Available at SSRN: http://ssrn.com/abstract=2304969 or http://dx.doi.org/10.2139/ssrn.2304969

Contact Information

Anat R. Admati (Contact Author)
Stanford Graduate School of Business ( email )
518 Memorial Way
Stanford, CA 94305-5015
United States
650-723-4987 (Phone)
650-725-6152 (Fax)

Peter M. DeMarzo
Stanford Graduate School of Business ( email )
518 Memorial Way
Stanford, CA 94305-5015
United States
650-736-1082 (Phone)
650-725-7979 (Fax)
HOME PAGE: http://www.stanford.edu/people/pdemarzo

National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Martin F. Hellwig
Max Planck Institute for Research on Collective Goods ( email )
Kurt-Schumacher-Str. 10
D-53113 Bonn, 53113
Germany
University of Bonn - Department of Economics
Adenauerallee 24-42
D-53113 Bonn
Germany
Paul C. Pfleiderer
Stanford Graduate School of Business ( email )
518 Memorial Way
Stanford, CA 94305-5015
United States
650-723-4495 (Phone)
650-725-7979 (Fax)

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