Debt Renegotiation and the Design of Financial Contracts

What is it about?

This study examines the design of financial contracts after renegotiations. It focuses on the degree of renegotiation as measured by the number of amendments to the contract. I find that the design of renegotiated financial contracts is not homogenous, although the most frequent amendments are to the loan’s amount and maturity. I show that the number of amendments increases with longer maturities. Collateral and bank reputation have the opposite effect. Creditors friendly environments with fewer renegotiation frictions increase the number of amendments. Overall, contractual, organizational, and legal features have a significant influence on the design of financial contracts after renegotiation.

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Why is it important?

First, initial maturity increases the number of different loan terms that are amended, while collateral and the lead bank’s reputation have the opposite effect. The main explanations for these findings are related to the impacts of information asymmetry, observed risk, and bargaining power on the contract design after renegotiation. Second, a more friendly environment and fewer renegotiation frictions for creditors, particularly their priority and recovery rates, allow for more amendments. Third, only the borrower’s size matters to the contract design while sound and profitable banks are more willing to accept more amendments when renegotiating a loan. These effects are economically significant as each standard deviation increase translates into 0.15 to 0.3 standard deviation changes in the number of amendments.