Monitoring and Structure of Debt Contracts

Authors

  • Cheol Park

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    • Department of Finance, Hong Kong University of Science and Technology. This paper is adapted from my dissertation at the University of Chicago. I thank Guangsug Hahn, In-Koo Cho, Robert Lucas, Jr., Christopher James, Mark Flannery, David P. Brown, Mathew Spiegel, Mark Rubinstein, Yuk-Shee Chan, Jeffrey Lacker, E. Han Kim, and other seminar participants at UCLA, UC Berkeley, the University of Michigan, the University of Florida, Federal Reserve Bank of Richmond, and HKUST. I especially thank René Stulz (the editor) and an anonymous referee for their detailed suggestions and comments. I am deeply indebted to Professors Raghu Rajan, Milton Harris, and Douglas Diamond for their guidance and encouragement. All errors remain mine.

Abstract

This paper presents a theory of optimal debt structure when the moral hazard problem is severe. The main idea is that the optimal debt contract delegates monitoring to a single senior lender and that seniority allows the monitoring senior lender to appropriate the full return from his monitoring activities. The theory explains (i) why debt contracts are prioritized, (ii) why short-term debt is senior to long-term debt, and (iii) why financial intermediaries usually hold short-term senior debt whereas long-term junior debt is widely held. Another implication of the theory is that covenant and maturity structures will be set to conform to the seniority structure.

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