Bank Loan Contract Design Through Learning and Renegotiating
20 Pages Posted: 26 Jan 2005
Date Written: January 25, 2005
We develop a model of dynamic debt based on a learning framework. Most of the literature on dynamic debt contracts focuses on information asymmetry as the determinant of renegotiation. We show, however, how differences in expectations may also trigger renegotiation. Such renegotiation occurs in many real-life situations, where both debtor and creditor learn about the true performance of an investment project. Although the two parties agreed beforehand on the conditions of the debt contract, they may develop different expectations over time. In our model, we show how at each moment in time, not only the realized profitability of a project but also the expectations regarding that profitability may form the impetus for renegotiation. This difference in expectations may be inherent in the nature of either party: Just as entrepreneurs may be overconfident and optimistic, banks may bear the opposite characteristics. Therewith, even when using the same information, both debtor and creditor may assign a different risk profile to the same project, which feeds the sentiment for renegotiation.
We work out the case for a lowering of the coupon rate, triggered by the debtor. Although the conventional literature would treat such renegotiation as a downside risk for the creditor, we readily provide conditions under which both parties benefit from the renegotiation. Therewith, our dynamic model of debt points to solutions that are Pareto efficient. An additional feature of our model is its discouragement of risk-seeking behavior on the side of the debtor. Although it might seem tentative for the debtor to increase the project's profitability, should increase should not be realized at the expense of income volatility. When working out a numerical example, we found that for every increment in income volatility, a similar increment in the minimum coupon rate was observed for which the creditor would be willing to renegotiate at all. Also, increasing the project's profits without increasing the amortization payments on the loan leads to a smaller chance for the renegotiation process to be successful. Although debtors will probably try to increase their project's profitability, such strategy alone does not suffice for a successful renegotiation process. We show that creditors may be willing to lower the coupon rate over a larger bandwidth, but then the profitable debtor must increase the speed of amortization as well.
Our model allows banks to safely enter into markets otherwise restricted to providers of equity or risky debt.
Keywords: Financial contracting, debt renegotiation, optimism
JEL Classification: G32, G33, L14
Suggested Citation: Suggested Citation