The Leverage Ratchet Effect

The Leverage Ratchet Effect

Firms’ inability to commit to future funding choices has profound consequences for capital structure dynamics. With debt in place, shareholders pervasively resist leverage reductions no matter how much such reductions may enhance firm value. Shareholders would instead choose to increase leverage even if debt levels are already high and new debt must be junior to existing debt. These asymmetric forces in leverage adjustments, which we call the leverage ratchet effect, cause equilibrium leverage outcomes to be history-dependent. When forced to reduce leverage, shareholders are biased toward selling assets relative to potentially more efficient alternatives such as pure recapitalizations.

Anat R. Admati, Peter M. DeMarzo, Martin F. Hellwig, and Paul Pfleiderer

The Journal of Finance

October 10, 2017

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By |2018-01-01T00:00:00+00:00January 1st, 2018|Financial Regulation, Reference, Systemic Risk/Financial Crises|