A Theory of Reverse Asset Substitution

Abstract

This paper studies Reverse Asset Substitution (RAS), an agency problem in which banks place investment and borrowing restrictions on firms as part of a strategy to extract surplus from the firms over multiple periods. RAS arises for firms that cannot access public debt markets due to agency problems and cannot commit to a lending bank for a long relationship. RAS provides a constrained optimal lending solution to ensure banks can lend to firms despite this limited commitment problem. Under RAS, the restrictions imposed by banks commit the firms to having a prolonged lending relationship. RAS reduces a firm’s investment and leverage compared to the case in which firms can commit to a lending relationship with the bank.

Keywords: Reverse Asset Substitution, Banking

JEL Classification: G21, G31, G32, G33, D21, D82