The Paradox of Pledgeability

Gromb`s web page

Abstract:

We develop a model in which collateral serves to protect creditors from the claims of competing creditors. We find that borrowers rely most on collateral when cash flow pledgeability is high, because this is when it is easy to take on new debt, diluting existing creditors. Creditors thus require collateral for protection against being diluted. This causes a collateral rat race that results in all borrowing being collateralized. But collateralized borrowing has a cost: it encumbers assets, constraining future borrowing and investment, i.e. there is a collateral overhang. Our results suggest that the absolute priority rule, by which secured creditors are senior to unsecured creditors, may have an adverse effect — it may trigger the collateral rat race.

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