Why is Bank Debt Senior? A Theory of Asymmetry and Claim Priority Based on Influence Costs

by Ivo Welch of the University of California

August 18, 1997

Abstract: This theory can explain why bank debt is universally senior, consistent with the presence of conflict (lawyers) and absolute priority violations in financial distress:  Better organized banks would more strongly contest priority in financial distress if they were junior. Because "deterrence" can reduce creditors' total expenses in a priority contest, the ex-post stronger lobbyist/litigant should be senior ex-ante. For equivalent reasons, the theory can advise when public debt should be senior to trade credit and/or implicit contracts, and can even suggest one rationale for the absolute priority rule (APR). The paper further shows that Chapter 11 creditor reimbursement procedures can lower overall costs.

Published in: Review of Financial Studies, Vol. 10, No. 4, (Winter 1997), pp. 1203-1236.

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