Why is Bank Debt Senior? A Theory of Parity Among Creditors
Ivo Welch
Executive Summary:
This paper investigates why banks are typically senior-debt holders. (That is, why Bank debt is almost always senior to publicly held bonds.) Welch develops a model that suggests that this is optimal in that is minimizes the fighting among debt holders. This fighting, were it to occur, is costly and reduces the total value of the firm.
Great analogy: (he presented at PSU on 4/3/95
"If you were the overseer of the school playground and your objective were to minimize the number of bloody noses, would you promise the weakest or the strongest child the top of the hill?"
Based on this model you would give it to the strongest child because the weaker children would know enough not to attack.
Similarly if banks, who are the best organized and in the best position to fight in a bankruptcy, are given the prime location so that the Junior debt holders will not waste money fighting because they know they will lose anyway and are merely "wasting" their money.
Suppose a firm has assets of $100, Sr. Debt of $75, Jr. Debt of $25. Thus at the time of bankruptcy if Junior debt holders do not fight, they will get $25, while the Sr. debt holders will get $75. However, if through "fighting" one side could increase their return they would fight. Suppose that it costs banks $1 to fight for an additional dollar. Hence they will not fight (NPV= 1-1=0). Suppose it costs the more unorganized, diffused, and less specialized bondholders $2 of fighting to win a single dollar. Here neither side has any incentive to fight. Further in Bankruptcy the firm pays all legal fees. These legal fees come, indirectly, from the Jr. Debt holders. Thus they will have no reason to fight since the money they spend will come directly out of the Jr. claim to the $25.
This idea is really an extension of Conflict theory from Economic Literature. (An offshoot of game theory with multiple players.) Here it comes into play since each player would be better off if there were no fighting (ie no legal fees) however since if one side does fight they both should fight. Structuring the better fighter’s debt as senior will minimize the probability of fighting and hence lower the expected fees of fighting. This will in turn increase the return to each type of debt.
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