The Paradox of Priority
21 Pages Posted: 15 Jan 2001
Date Written: Novermber 2002
The ubiquity of bank seniority is now a widely accepted fact in the academic literature. At the same time, trade creditors are sometimes granted a purchase money security interest in the materials or equipment they provide the firm. These two conflicting facts present a puzzle: Why would banks willingly give up a valuable priority claim on the firm, but only with respect to a subset of the firm's assets; We propose a resolution to this paradox of priority by arguing that trade creditors are better able to liquidate the materials they supply to a firm. When trade creditors have a security interest in these assets, their claims are state-contingent, and therefore dependent on the value of the assets pledged as collateral. Surprisingly, this ability of trade creditors to more efficiently liquidate the materials they supply to a firm also makes it desirable to subordinate the non-collateralized portion of their claims. Doing so increases the face value of a trade creditor's claim for a given level of borrowing, thereby increasing the "liquidation bang" from each trade credit buck. This combined priority structure maximizes social welfare by reducing the firm's overall cost of funding.
JEL Classification: G21, G32
Suggested Citation: Suggested Citation