Implications of Debt Renegotiation for Optimal Bank
Policy and Firm Behavior
Department of Economics, Soongsil University, Seoul, Korea
SCOTT C. LINN
Division of Finance, University of Oklahoma, Norman, Oklahoma, U.S.A.
Department of Economics, University of Bahrain, Bahrain
Abstract. This paper analyzes the problems associated with the renegotiation of debt contracts involving a bank
(the lender) and a firm (the borrower) when the latter is operated by a risk averse manager. Firms undertake risky
projects with loan capital borrowed from the bank. When a firm cannot pay off a loan it is technically bankrupt.
Both the borrower and the lender may however experience a Pareto-improvement in their positions by renegoti-
ating the loan. By renegotiating the terms of the debt the financially distressed firm can avoid the stigmatization
of bankruptcy and the bank can avoid the costs of seizing the borrower’s assets. However, our main finding is
that, from the bank’s point of view, renegotiation as a policy of recovering loan payments may be inefficient in
practice because of a) false bankruptcy claims and b) moral hazard problems associated with exposure of the bor-
rowing firm to the risk of default. We present a solution to the false bankruptcy claim problem that involves a
mixed strategy between asset seizure by the bank and debt renegotiation.
Keywords: Debt Renegotiation, Bank Policy, Agency Problems
Bank loan activity and its importance in the financing of domestic U.S. business is signifi-
cant. Federal Reserve Flow of Funds data for instance indicate that short-term debt for non-
farm, non-financial corporations (seasonally adjusted) constituted on average 12% of total
corporate funds sources for the period 1980–1990. As a percentage of total debt finance,
short–term debt averaged about 26.5%. The importance of short–term financing is rein-
forced by the studies of Duca (1992) and Duca and Vanhoose (1990) which show that bank
loans and loan commitments comprise an important source of credit for domestic U.S. firms.
One dimension of bank loan activity which has received only limited attention, but which is
a common, known empirical phenomenon, is the renegotiation process. Little is known
about whether ex post debt renegotiation is an optimal policy from the perspective of a value
The analysis presented in this paper details the implications of such a
bank policy for both the bank and for the borrower, within a limited information setting.
This paper analyzes the problems associated with the renegotiation of debt contracts
involving a bank (the lender) and a firm (the borrower) when the latter is operated by a
risk averse manager. Firms undertake risky projects with loan capital borrowed from the
bank. When a firm cannot pay off a loan it is technically bankrupt. Both the borrower and
the lender may however experience a Pareto-improvement in their positions by renegotiat-
Review of Quantitative Finance and Accounting, 8 (1997): 163–179
© 1997 Kluwer Academic Publishers, Boston. Manufactured in The Netherlands.