Why is Bank Debt Senior? A Theory of Priority Based on Influence Costs

Abstract

This paper provides a theory why bank debt is universally senior, consistent with the presence of conflict (lawyers) and absolute priority violations in financial distress: banks would more strongly contest the priority structure in financial distress if they were junior, because they are both better organized than public debt and more appreciative of a toughness reputation in repeat relationships with other clients. This paper identifies the conditions under which firms find it efficient to award the ex-post stronger lobbyist/litigant ex-ante priority, because "deterrence" can reduce total creditors' expenses associated with a priority contest. For equivalent reasons, the theory can advise when public debt should be senior to trade credit and/or implicit contracts, and can even suggest one rationale for the absolute priority rule (APR). The paper further shows that overall creditors' contest expenses can be lower when the firm pays, thus providing a rationale for Chapter 11 creditor reimbursement procedures.

JEL Classification: G21, G31