Why is Bank Debt Senior? A Theory of Priority Among Creditors

Abstract

Theories of banks as efficient monitors would suggest that bank debt should be junior to other creditors in order to precipitate bankruptcy when other creditors are still in- the-money. This paper provides an explanation why bank debt is usually senior: banks would more strongly contest the priority structure in financial distress if they were junior, because they are both better organized than public debt and more appreciative of a toughness reputation in repeat relationships with other clients. This paper identifies the conditions under which it can be efficient to award the ex-post stronger litigant ex-ante priority, because it reduces the creditors' expenses associated with a priority contest. For equivalent reasons, the theory can advise when public debt should be senior to trade credit and/or implicit contracts, and even suggests one rationale for the absolute priority rule (APR).This paper is available for print via anonymous ftp: Postscript: next.agsm.ucla.edu: ~/academic.finance/bankdebt.ps HP LJ (binary/no figures): next.agsm.ucla.edu: ~/academic.finance/bankdebt.hp

JEL Classification: G21