Will Gornall
Will Gornall
Job Market Paper
This paper uses bank-level fragility to explain why bank loans are universally senior. High leverage makes banks more fragile than the marginal bond investor and thus more willing to pay for safety. Seniority reduces loan-level systematic risk, which mitigates the bank's financial distress costs. If banks need skin in the game, holding junior debt may create stronger incentives to screen or monitor than holding the same amount of senior debt. Nevertheless, bank seniority remains efficient because simultaneously increasing the size and seniority of a loan preserves bank incentives while reducing bank-level capital structure costs. This holds because a large senior loan imposes losses and capital structure costs when borrower value is lowest and the bank is most likely to have shirked. Adding insured deposits or bailouts to my model makes seniority even more attractive to banks, as senior claims benefit the most from subsidies to tail risk. Beyond these seniority structure results, my model provides natural explanations for why procyclical firms avoid bank loans, why bank lending falls during recessions, and a host of other debt structure phenomena.
Working Papers
We develop a model of the joint capital structure decisions of banks and their borrowers. Our model simultaneously solves the outstanding puzzles of high bank leverage and low firm leverage. Strikingly high bank leverage of 85% or higher emerges naturally from the interplay between two sets of forces. First, seniority and diversification reduce bank asset volatility by an order of magnitude relative to that of their borrowers. Second, previously unstudied supply chain effects mean that highly levered financial intermediaries can offer the lowest interest rates. Low asset volatility enables banks to take on high leverage safely; supply chain effects compel them to do so. Low firm leverage arises because borrowers internalize the systematic risk costs they impose on their lenders. This presents a potential answer to the long-standing theoretical puzzle of low firm leverage.
Work in Progress
Will Gornall
Will Gornall