No-fault default, chapter 11 bankruptcy, and financial institutions
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w28341.pdf
Description
Accepted version
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315.51 KB
Format
Adobe PDF
Checksum (MD5)
7d25b32421d4bcad0601b62e7581b056
Author(s)
Merton, Robert C
Thakor, Richard T
Date Issued
2021
Journal
Journal of Banking and Finance
Publisher
Elsevier BV
Citation
Merton, Robert C and Thakor, Richard T. 2021. "No-fault default, chapter 11 bankruptcy, and financial institutions." Journal of Banking and Finance, 140.
Version
Original manuscript
Abstract
© 2021 This paper analyzes the costs and benefits of a no-fault-default debt structure as an alternative to the typical bankruptcy process. We show that the deadweight costs of bankruptcy can be avoided or substantially reduced through no-fault-default debt, which permits a relatively seamless transfer of ownership from shareholders to bondholders in certain states of the world. We show that potential costs introduced by this scheme due to risk shifting can be attenuated via convertible debt, and we discuss the relationship of this to bail-in debt and contingent convertible (CoCo) debt for financial institutions. We then explore how, despite the advantages of no-fault-default debt, there may still be a functional role for the bankruptcy process to efficiently allow the renegotiation of labor contracts in certain cases. In sharp contrast to the human-capital-based theories of optimal capital structure in which the renegotiation of labor contract in bankruptcy is a cost associated with leverage, we show that it is a benefit. The normative implication of our analysis is that no-fault-default debt, when combined with specific features of the bankruptcy process, may reduce the deadweight costs associated with bankruptcy. We discuss how an orderly process for transfer of control and a predetermined admissibility of renegotiation of labor contracts can be a useful tool for resolving financial institution failure without harming financial stability.
MIT Department
Sloan School of Management
Terms of Use
Creative Commons Attribution-NonCommercial-NoDerivs License
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DOI of Published Version
https://doi.org/10.1016/J.JBANKFIN.2021.106066
