Safe Assets and Dangerous Liabilities: How Bank-Level Frictions Explain Bank Seniority

Abstract

This paper uses bank fragility to explain why bank loans are senior in firm capital structure. High leverage makes banks more vulnerable to financial distress than the typical bond investor, and thus makes banks willing to pay for seniority. Bank seniority emerges even when banks need skin in the game, as bank effort has more impact on a large senior loan than on a smaller junior claim with the same systematic risk. Adding deposit insurance or bailouts adds a subsidy to tail risk, which makes large senior claims even more attractive to banks. Empirically, this model explains why procyclical firms avoid bank loans and provides a host of debt structure predictions.

Keywords: Seniority, debt structure, banks, financial intermediaries, capital structure

JEL Classification: G2, G21, G23, G28, G3, G32, G33, G38