42 Pages Posted: 30 Mar 2012
Date Written: March 23, 2012
We analyze shareholders’ incentives to change the leverage of a firm that has already borrowed substantially. As a result of debt overhang, shareholders have incentives to resist reductions in leverage that make the remaining debt safer. This resistance is present even without any government subsidies of debt, but it is exacerbated by such subsidies.
Our analysis is relevant to the debate on bank capital regulation, and complements Admati et al. (2010). In that paper we argued that subsidies that favor debt over equity are the key reason that banks funding costs would be lower if they “economize” on equity. Subsidies come from public funds, and reducing them does not represent a social cost. It is thus irrelevant for assessing regulation. Other arguments made to support claims that “equity is expensive” are flawed.
Like reduction in subsidies, the effects of leverage reduction on bank managers or shareholders do not represent a social cost. In fact, we show that debt overhang creates inefficiency, since shareholders would resist recapitalization even when this would increase the combined value of the firm to shareholders and creditors. Moreover, debt overhang creates an “addiction” to leverage through a ratchet effect. In the presence of government guarantees, the inefficiencies of excessive leverage are not fully reflected in banks’ borrowing costs.
Since banks’ high leverage is a source of systemic risks and imposes costs on the public, resistance to leverage reduction leads to social inefficiencies. The main beneficiaries from high leverage may be bank managers. The majority of the banks’ shareholders, who hold diversified portfolios and who are part of the public, are likely to be net losers. Our analysis highlights the critical importance of effective capital regulation and high equity requirements, especially for large and “systemic” financial institutions.
We analyze shareholders’ preferences when choosing among various ways leverage can be reduced. We show that, with homogeneous assets, if the firm’s security and asset trades have zero NPV, and the firm has a single class of debt outstanding, then shareholders find it equally undesirable to deleverage through asset sales, pure recapitalization, or asset expansion with new equity. When these conditions are not met, shareholders can have strong preferences for one approach over another. For example, if the firm can buy back junior debt, asset sales are the preferred way to reduce leverage. This preference for asset sales, or “deleveraging,” can persist even if such sales are inefficient and reduce the total value of the firm.
Keywords: capital regulation, financial institutions, capital structure, “too big to fail,” systemic risk, bank equity, debt overhang, underinvestment, recapitalization, deleveraging, bankruptcy costs, Basel
JEL Classification: G21, G28, G32, G38, H81, K23
Suggested Citation: Suggested Citation
Admati, Anat R. and DeMarzo, Peter M. and Hellwig, Martin F. and Pfleiderer, Paul C., Debt Overhang and Capital Regulation (March 23, 2012). Rock Center for Corporate Governance at Stanford University Working Paper No. 114; MPI Collective Goods Preprint, No. 2012/5. Available at SSRN: https://ssrn.com/abstract=2031204 or http://dx.doi.org/10.2139/ssrn.2031204