Multiple Lenders, Strategic Default and Covenants
57 Pages Posted: 17 Jan 2013 Last revised: 9 Aug 2014
Date Written: June 2014
We study competition in capital markets subject to moral hazard when investors cannot prevent side trading. Perfect competition is impeded by entrepreneurs’ threat to borrow excessively from multiple lenders and to shirk. As a consequence, investors earn positive rents at equilibrium. We then analyze how investors’ ability to design financial contracts with covenants deals with this counterparty externality. We show that enlarging investors’ contracting opportunities generates a severe market failure: with covenants, market equilibria are indeterminate and Pareto ranked. Market outcomes are then determined by designing specific financial institutions. Information sharing systems restore efficiency but leave a positive rent to investors. A mechanism of investors-financed subsidies to entrepreneurs mitigates the threat of default and sustains the competitive allocation.
Keywords: Counterparty Externality, Covenants, Nonexclusive Competition, Strategic Default.
JEL Classification: D43, D82, G33
Suggested Citation: Suggested Citation