The Optimal Mix of Bank and Market Debt: An Asset Pricing Approach

Abstract

This paper examines the optimal mix and priority structure of bank and market debt using a tax shield-bankruptcy cost tradeoff model where the only unique feature of banks is their ability to renegotiate. Closed-form expressions are derived for the values of renegotiable bank debt, non-renegotiable market debt, equity, and levered firm values. Optimal debt structure hinges upon the division of ex post bargaining power between the firm and bank. Weak firms utilize bank debt exclusively. Strong firms use a mixture of bank and market debt, with bank debt senior. The model explains: (i) why small firms use bank debt exclusively; (ii) why large firms employ mixed debt financing; (iii) why bank debt is senior; and (iv) why firms shift from bank debt into a mixture of market and bank debt over their life-cycle. Optimal debt contracts entail Absolute Priority, and we provide estimates of the cost of ex post priority violations across creditor classes.

Keywords: Banking, Capital Structure, Priority, Contingent Claims Pricing

JEL Classification: G13, G32, G33