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2017 | Supplement | Chapter

4. Economic Analysis of Excess Additional Credit (Loan Evergreening)

Authors : Hiroyuki Seshimo, Fukuju Yamazaki

Published in: Priority Rule Violations and Perverse Banking Behaviors

Publisher: Springer Singapore

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Abstract

In this chapter, using the basic model explained in Chap. 3, we explain how APR violations lead to credit crunches and loan evergreening (excess additional credt). First, we derive the condition in which the inefficient additional investment can be financed through an outside investor under APR violation. Then, we demonstrate that if the degree of the APR violation becomes high enough for the outside creditor to finance an inefficient additional investment, the senior creditor, who has the legal right to liquidate the firm, however will not liquidate it. Then the senior creditor postpones the liquidation of the inefficient defaulting firm. Furthermore, we demonstrate that the outside creditor tries to finance the inefficient additional investment to partially deprive the initial coeditor of his credit value. In this case, the senior creditor him/herself has the incentive to carry out the inefficient additional loan (loan evergreening) as countermeasure against the outside creditor. Expecting this ex post inefficient lending, the senior creditor does not extend an initial loan for an efficient investment, so that the credit crunch arises.

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previous chapter Fundamental Structure of Our Model and the Result in the Case with no APR Violations

next chapter Empirical Evidence

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See Peek and Rosengren (2003) regarding the “evergreening” hypothesis for inefficient banking behavior in Japan in the 1990s. Following the authors, we use the term “loan evergreening” to represent inefficient additional lending by Japanese banks.

See Schwartz (1989).

We are mainly interested in the priority violation among creditors.

Such payments cannot be enforced in liquidation—at least, not in Japan. The expectation of such a subsidy by managers also provides a perverse incentive to the managers of other financially distressed firms because the subsidy is given when the managers may make inefficient decisions. Thus, other firm managers would like to mimic such a perverse manner.

The basic model and notations are as follows (see Chap. 3 for more detail). Assume that a firm has a fixed and indivisible asset A and an initial investment opportunity I at time 0. The initial investment yields random cash flow θ ∈ [0, $ \bar{\theta } $] with distribution function F(·) and support [0, $ \bar{\theta } $] at time 1. We suppose this initial investment opportunity is efficient, that is,

$$ V_{\theta } \equiv E(\theta ) = \int\limits_{\,0}^{{\,\bar{\theta }}} {\theta dF(\theta )} > I. $$

(3.1)

After this initial investment, but before time 1, the debtor firm and the investors know the accurate realizing value $ \tilde{\theta } $. Then the debtor firm gets an additional investment opportunity ΔI. We refer to this as time ½. By this additional investment, the firm obtains not only cash flow $ \tilde{\theta } $ at time 1, but also the total value of firm x at time 2. The total value $ x \in \left[ {0,\bar{x}} \right] $ is defined including the fixed asset value and it is a random variable with the distribution function G(x) and support $ \left[ {0,\bar{x}} \right] $. Furthermore, we assume the density function g(∙) is strictly positive for all $ x \in \left[ {0,\bar{x}} \right] $. We suppose that the additional investment opportunity is inefficient, that is,

$$ V_{x} \equiv E(x) = \int\limits_{0}^{{\bar{x}}} {xdG(x)} < \Delta I + A. $$

(3.2)

We denote the face value of the debt for the initial investment I by B, including interest payments. This debt matures at time 1. We denote the additional debt for the additional investment ΔI by ΔB when it is financed by the senior creditor, and ΔD when it is financed by outside investors. This face value of the debt also includes interest payments and it matures at time 2. We assume that the financial market is competitive.

The claim w is not set as w < ΔD. Instead, ΔD is determined given the claim w.

Expressed as an equation, the marginal risk-sharing effect of the APR violation claim w is described as $ 1 + {{\partial V_{{B - \tilde{\theta }}} (w)} \mathord{\left/ {\vphantom {{\partial V_{{B - \tilde{\theta }}} (w)} {\partial w}}} \right. \kern-0pt} {\partial w}} $.

The second and third terms are the expected repayment of junior debt without claim w. This payment is subordinate to the remaining senior debt $ B - \tilde{\theta } $ and the claim w, which has super-priority when the debtor firm becomes insolvent. Note that, $ B - \tilde{\theta } + w + (\Delta D - w) = B - \tilde{\theta } +\Delta D $.

That is, $ \int_{{B - \tilde{\theta } + \Delta D}}^{{\bar{x}}} {\left\{ {x - (B - \tilde{\theta }) - \Delta D} \right\}dG(x)} \ge { \hbox{max} }\left\{ {\tilde{\theta } + A - B,0} \right\} $. (3.5)

This proposition holds only if the firm is financed by the outside creditor. That is, it holds given the latter condition in Lemma 4.2 is satisfied.

There is a possibility that the existing (senior) creditor will liquidate the debtor firm at time 1, even after lending additional money to the debtor firm at time ½, because s/he cannot transfer the continuation risk to the other creditors. Thus, when the existing senior creditor must make the debtor commit to not liquidating the firm at time 1, s/he defers the due date of the remaining senior debt until time 2 and extends an additional loan. As a result, the debtor firm does not default at time 1, even when $ \tilde{\theta } < B $.

Note that $ V_{{B - \tilde{\theta }}} (w) $ is decreasing in θ.

Note that the creditor can receive repayment B even under θ < B because the debtor firm can be liquidated as long as θ > θ ₁.

Bebchuk, L. A. (2002). Ex ante costs of violating absolute priority in bankruptcy. The Journal of Finance, 57(1), 445–460. doi:10.1111/1540-6261.00427.CrossRef

Coase, R. H. (1960). The problem of social cost. Journal of Law and Economics, 3, 1–44.CrossRef

Longhofer, S. D. (1997). Absolute priority rule violations, credit rationing, and efficiency. Journal of Financial Intermediation, 6(3), 249–267.CrossRef

Peek, J., & Rosengren, E. S. (2003). Unnatural selection: Perverse incentives and the misallocation of credit in Japan. NBER Working Paper 9643 (http://www.nber.org/papers/w9643).

Schwartz, A. (1989). A theory of loan priorities. The Journal of Legal Studies, 18(2), 209–261.CrossRef

Yamazaki, F., & Seshimo, H. (2000). Land Mortgage and Tenant Security. Journal of Social Science, 51(3), Institute of Social Science, University of Tokyo (in Japanese).

Title: Economic Analysis of Excess Additional Credit (Loan Evergreening)
Authors: Hiroyuki Seshimo
Fukuju Yamazaki
Publisher: Springer Singapore
Book: Priority Rule Violations and Perverse Banking Behaviors
Print ISBN: 978-981-10-5851-6

Electronic ISBN: 978-981-10-5852-3

Copyright Year: 2017
DOI: https://doi.org/10.1007/978-981-10-5852-3_4