Insolvency Resolution and the Missing High Yield Bond Markets

Abstract

In many countries, bankruptcy is associated with low recovery by creditors. We develop a model of corporate credit markets in such an environment. Corporate credit is provided by either a bond market or risk-averse banks. Restructuring of insolvent firms happens out of court if in-court bankruptcy is inefficient, giving banks an advantage over bondholders. Riskier borrowers will use bank loans anywhere, but also bonds when bankruptcy is efficient. The model matches empirical debt mix patterns better than fixed-issuance-cost models. Across systems, efficient bankruptcy should be associated with more bond issuance by high-risk borrowers. This effect is small or absent for safe firms. We find that both predictions hold both cross-country and using insolvency reforms as natural experiments. Our empirical estimates suggest that a one-standard-deviation increase in the efficiency of bankruptcy is associated with an increase in the stock of corporate bonds equal to 5% of firm assets. This is equivalent to two thirds of the difference between the US and other countries. Most external financing to corporations is debt, i.e. financing with a fixed horizon and a predetermined repayment schedule. Among the dimensions in which corporate debt contracts vary, such as maturity and seniority, one stands out as particularly salient: the difference between intermediated debt (such as bank loans) and non-intermediated debt (bonds and commercial paper). Bank loans are associated with more screening, monitoring and intervention, but are held in much more concentrated fashion (Diamond 1991). Corporations use both loans and bonds in large amounts, and individual firms often use both simultaneously, showing willingness to switch. 1 However, there are strong cross-country differences in the mix of debt use: for European listed companies the amount of loans outstanding is more than twice the amount of bonds. US firms, on the contrary, have less loans outstanding than bonds. Figure 1 shows aggregate amounts of bond debt, bank loans, and other debt for publicly listed corporations in North America, Europe, and Asia in 2010, demonstrating the very large geographical differences. 2 This international variation in the corporate debt mix, not previously documented in detail, cannot easily be explained by standard models of bank-bond choice, which focus on the superior monitoring ability of banks (Diamond 1991) or the fixed costs associated with bond issuance (e.g. Bhagat and Frost 1986). These forces do not vary in an obvious way across countries, especially not on the scale that could plausibly cause these wide differences in debt mix. After all, firms need monitoring both in France and Canada, and banks presumably screen and monitor their small and large borrowers with approximately the same technology.We propose instead that a better explanation of the broad cross-country patterns is offered by variation in the efficiency with which insolvency is resolved. Countries exhibit substantial differences in how creditors in insolvent f...

Bond Finance, Bank Finance, and Bank Regulation

“…The liquidation efficiency of bank credit is more important for risky firms than for safe firms because safe firms are less likely to face costly liquidation. This setting is consistent with empirical findings in Rauh and Sufi (2010) and Becker and Josephson (2016). Bank credit does not always dominate bond credit for risky firms.…”

“…In this subsection, I conduct three policy experiments, and discuss whether and how the optimal capital requirement depends on the structure of the bond market. In the first experiment, I vary the liquidation cost of bondholders κ d , and characterize the relationship between the optimal capital requirement and the development of the bond market (Djankov et al, 2008;Becker and Josephson, 2016). In the second and third policy experiments, I investigate the policy implication of the risk profile of borrowing companies in the bond market.…”

Trade credit and supplier competition

“…For example, Froot, Scharfstein, and Stein (1993) and Bernanke, Gertler, and Gilchrist (1999) among others, show that convexity of the cost of debt financing arises when creditors can observe the firm's cash flows only at a cost. Other rationales for convex cost of debt financing include agency problems (e.g., Myers, 1977), adverse selection (e.g., Stein, 1998), regulatory capital requirements or managerial risk aversion (e.g., Becker and Josephson, 2016). For parsimony, we adopt convex cost of bank credit by assumption without explicitly modeling its micro foundations.…”

The Entrepreneurial Society

“…If they are too hastily shut down, with their remaining assets shifted out to creditors, the result could be excessive value destruction. Not all insolvent operations should be considered a failure: it is often sufficient that the current owners lose their equity, that the debt is restructured, and that the consortium of debtors finds a new controlling owner after restructuring (Becker and Josephson 2016). Reforms taking these concerns into account would be in line with the principle of justifiability, as they balance the interests of the entrepreneur and other stakeholders in the venture.…”