Why is Bank Debt Senior? A Theory of Priority Among Creditors

Abstract:     
Theories of banks as efficient monitors would suggest that bank debt should be junior to other creditors in order to precipitate bankruptcy when other creditors are still in- the-money. This paper provides an explanation why bank debt is usually senior: banks would more strongly contest the priority structure in financial distress if they were junior, because they are both better organized than public debt and more appreciative of a toughness reputation in repeat relationships with other clients. This paper identifies the conditions under which it can be efficient to award the ex-post stronger litigant ex-ante priority, because it reduces the creditors' expenses associated with a priority contest. For equivalent reasons, the theory can advise when public debt should be senior to trade credit and/or implicit contracts, and even suggests one rationale for the absolute priority rule (APR).This paper is available for print via anonymous ftp: Postscript: next.agsm.ucla.edu: ~/academic.finance/bankdebt.ps HP LJ (binary/no figures): next.agsm.ucla.edu: ~/academic.finance/bankdebt.hp

JEL Classification: G21

working papers series