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

May 30, 2014

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

Abstract:     
We show that conflicts of interest with creditors lead shareholders to resist all forms of leverage reduction, even when reducing leverage would increase firm value. By contrast shareholders will generally favor increase in leverage, even if it destroys firm value. This leverage “ratchet effect” is present even under the perfect market conditions, but is exacerbated by standard frictions. Unlike theories based on asymmetric information, the leverage ratchet effect explains shareholders' resistance to earning retentions and rights offerings as ways to reduce leverage.

When forced to reduce leverage, by creditors or by regulation, firms can buy back debt using proceeds obtained either by selling assets or from issuing new equity. It can also purchase new assets funded by new equity. We present conditions under which shareholders are indifferent among these alternatives, considering all equally undesirable. We then analyze how various frictions affect shareholders’ choice among leverage-reduction methods.

Our results are particularly relevant to banking, where the ratchet effect is especially strong and not fully addressed by debt covenants. We highlight why effective capital regulation is important for constraining inefficiently excessive bank borrowing and offer insights to banks’ response to requirements specified in the form of leverage ratios.

Number of Pages in PDF File: 52

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

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Date posted: August 2, 2013 ; Last revised: June 23, 2014

Suggested Citation

Admati, Anat R. and DeMarzo, Peter M. and Hellwig, Martin F. and Pfleiderer, Paul C., The Leverage Ratchet Effect (May 30, 2014). Preprints of the Max Planck Institute for Research on Collective Goods Bonn 2013/13; Rock Center for Corporate Governance at Stanford University Working Paper No. 146. 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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