The Pitfalls of Pledgeable Cash Flows: Soft Budget Constraints, Zombie Lending and Under-Investment

30 Pages Posted: 11 Mar 2021

See all articles by Dan Bernhardt

Dan Bernhardt

University of Illinois at Urbana-Champaign - Department of Economics

Kostas Koufopoulos

University of York

Giulio Trigilia

University of Rochester - Simon Business School

Date Written: January 4, 2021

Abstract

We show that when borrowers are privately informed about their creditworthiness and lenders have a soft budget constraint, efficient investment requires a limit on the fraction of a firm’s cash flows that can be pledged to outsiders. That is, pledgeability should neither be too low nor too high. An increase in pledgeability, or, more broadly, creditor rights, can either promote re-investment in zombie firms, which increases other firms’ cost of capital, or it can lead to inefficient under- investment, depending on the composition of equilibrium credit demand. Thus, greater pledgeability can reduce net social surplus, and even trigger a Pareto loss.

Keywords: Pledgeability, Investment Efficiency, Soft Budget Constraint, Asymmetric Information, Collateral, Zombie Lending, Under-Investment

JEL Classification: G21, G32, G33, G38

Suggested Citation

Bernhardt, Dan and Koufopoulos, Kostas and Trigilia, Giulio, The Pitfalls of Pledgeable Cash Flows: Soft Budget Constraints, Zombie Lending and Under-Investment (January 4, 2021). Available at SSRN: https://ssrn.com/abstract=3759075 or http://dx.doi.org/10.2139/ssrn.3759075

Dan Bernhardt

University of Illinois at Urbana-Champaign - Department of Economics ( email )

1206 South Sixth Street
Champaign, IL 61820
United States
217-244-5708 (Phone)

Kostas Koufopoulos

University of York ( email )

Heslington
York, YO1 5DD
United Kingdom

Giulio Trigilia (Contact Author)

University of Rochester - Simon Business School ( email )

Rochester, NY 14627
United States

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