Ebook Corporate Debt Restructuring: Evidence on Lender Coordination in Financial Distress
In the aftermath of the 2001 Swissair debacle, Oliver Hart noted that Swissair, until recently one of the world’s most respected airlines, could probably have been saved if a mechanism had been in place to engineer a coordination among all lenders, thereby avoiding the run on debtor assets [see Hart 2001].
In this paper we investigate a financial institution, the bank pool, that is able to eliminate the risk of a corporate run, and that is common in the German financial system. The bank pool is a new institution in the sense that to the best of our knowledge it has not been studied thoroughly by economists before, and it is widely unknown, even among scholars of corporate finance.
Much of the recent literature on the pricing of debt, on the design of debt contracts and, with a broader perspective, on the properties of the banking system, builds on a common theme, that is the borrower-lender bargaining process when firms are in distress, and its implications for the financing of the firm. Two strands of the literature have focussed their attention on the issue of lender coordination. Bolton and Scharfstein [1996] offer an explanation of why firms will choose more than one creditor.
Multiple lenders have the advantage of lowering the firm’s incentive to default strategically, and therefore increase the ex-ante probability of proper and timely repayment of debt. On the other hand, multiple lenders have the disadvantage of lowering expected payoff in liquidity default. However, the disadvantage can be reduced if lenders commit themselves to a voting rule concerning asset sale decisions. In a different setting, Morris and Shin [1999] analyze the common pool problem of multiple lenders in corporate distress.
E¢cient investment and liquidation decisions are not automatically guaranteed, since the incentives of lenders follow private rather than public welfare maximization. With many lenders, coordinated behavior is not easily achieved. The risk of coordination failure will be anticipated by borrowers and lenders. Coordination risk is a variant of the common pool problem, similar in spirit to Diamond and Dybvig’s [1983] bank run problem.
In this paper, we test empirically the value of lender coordination, relying on a unique data set that contains detailed credit file information sampled from distressed clients of six leading German banks. It contains a comprehensive array of lending-related data on medium-sized corporates that were in distress at least once during the period 1992-1997. The basic objective of our study will be to explore how banks behave in the event of a corporate distress.
The major questions asked are: ”Do banks systematically coordinate their interests, and if so, how is lender coordination achieved? Second, and most importantly, what real economic consequences are associated with lender coordination, and what are its major determinants? Finally, is the success of a workout predictable, and if so, which determinants matter?”. We find that over the past decades the banking industry in Germany has developed a widely accepted and fine-tuned contractual arrangement that harmonizes lender interests in the event of borrower distress. This unification of interests is achieved by forming a so-called ”bank pool”. Our data set allows us to identify when these pools are formed and what impact they exert on workout, in particular, on workout success. We will argue that the sustainability of the institution bank pool is closely related to the structure of the insolvency code, with significant differences between the German code and the US code (Chapter 11).
The main empirical results of this study suggest that multiple lending is widespread among medium-sized firms in Germany, and that explicit coordination among these lenders starting at the onset of financial distress is very common. Coordination is typically achieved through the formation of bank pools. These pools aim at the reorganization of the common distressed borrower. Bank pools with few member banks significantly increase the likelihood of a successful turnaround during a reorganization process, whereas pools with many member banks tend to decrease turnaround probability, extending the time needed to resolve distress. The formation of the pool itself depends on the severity of the initial distress shock, the number of firm’s bank relationships and their heterogeneity in terms of debt outstanding.
We will proceed as follows. Section 2 gives a brief account of the relevant theoretical and empirical literature and motivates our special interest in the question of lender coordination. Section 3 lays out the institutional details of the bank pool and discusses the typical contract design. Section 4 states our major hypotheses. Section 5 describes the data set in some detail, including the clients’ debt structure and the occurrence and structure of bank pools. Section 6 derives the main results. Section 7 discusses our findings, relating them to the structure of the insolvency code.
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