Implications of debt renegotiation for optimal bank policy and firm behavior

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 renegotiating 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 borrowing 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.