Insiders and Outsiders: The Choice between Informed and Arm's-Length Debt



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    • Assistant Professor of Finance, University of Chicago. I am indebted to Mitchell Berlin, Douglas Diamond, Oliver Hart, Donald Lessard, Antonio Mello, Stewart Myers, John Parsons, Canice Prendergast, David Scharfstein, Steven Sharpe, Jeremy Stein, René Stulz (the editor), Miguel Villas-Boas, and an anonymous referee for valuable comments and advice. I thank David Scharfstein for directing me toward this area. All errors are, of course, my own.


While the benefits of bank financing are relatively well understood, the costs are not. This paper argues that while informed banks make flexible financial decisions which prevent a firm's projects from going awry, the cost of this credit is that banks have bargaining power over the firm's profits, once projects have begun. The firm's portfolio choice of borrowing source and the choice of priority for its debt claims attempt to optimally circumscribe the powers of banks.