Leverage ratchet effect

Other versions of this item: Anat R. Admati, Anat R. Nyborg, Discussion Papers.

Bank leverage, welfare, and regulation. Admati, Anat R. Debt overhang and capital regulation. Fallacies, irrelevant facts, and myths in the discussion of capital regulation: Why bank equity is not socially expensive. Fallacies, irrelevant facts, and myths in the discussion of capital regulation: Why bank equity is not expensive.

Leverage ratchet effect

We analyze equilibrium leverage dynamics in a dynamic tradeoff model when the firm is unable to commit to a leverage policy ex ante. We develop a methodology to characterize equilibrium equity and debt prices in a general jump-diffusion framework, and apply our approach to the standard Leland setting. Absent commitment, the leverage ratchet effect Admati et al. On the other hand, countervailing effects of asset growth and debt maturity cause leverage to mean-revert towards a long run target. In equilibrium, bond investors anticipate future leverage increases and require significant credit spreads even when the distance to default is large. As a result, the tax benefits of future debt increases are fully dissipated, and equilibrium equity values match those in a model where the firm commits not to issue new debt. Despite the absence of transactions costs, an increase in profitability causes leverage to decline in the short-run, but the rate of new debt issuance endogenously increases so that leverage ultimately mean-reverts. The target level of leverage, and the speed of adjustment depends critically on debt maturity; nonetheless, in equilibrium shareholders are indifferent toward the debt maturity structure. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. Download Citation Data. Peter M. Share X LinkedIn Email. Working Paper DOI Issue Date November

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In the absence of prior commitments or regulations, shareholder-creditor conflicts give rise to a leverage ratchet effect, which induces shareholders to resist reductions while favoring increases in leverage even when total-value maximization calls for the opposite. Unlike inefficiencies based on asymmetric information, the leverage ratchet effect applies to all forms of leverage reduction, including earnings retentions and rights offerings. The leverage ratchet effect is present even in the absence of frictions other than the inability to write complete contracts. The effect creates an agency cost of debt that lowers the value of the leveraged firm. Standard frictions magnify the impact of the effect.

Leverage ratchet effect

A ratchet effect is an instance of the restrained ability of human processes to be reversed once a specific thing has happened, analogous with the mechanical ratchet that holds the spring tight as a clock is wound up. It is related to the phenomena of featuritis and scope creep in the manufacture of various consumer goods, and of mission creep in military planning. In sociology, "ratchet effects refer to the tendency for central controllers to base next year's targets on last year's performance, meaning that managers who expect still to be in place in the next target period have a perverse incentive not to exceed targets even if they could easily do so". Garrett Hardin , a biologist and environmentalist, used the phrase to describe how food aid keeps people alive who would otherwise die in a famine. They live and multiply in better times, making another bigger crisis inevitable, since the supply of food has not been increased. Peacock and Wiseman found that public spending increases like a ratchet following periods of crisis. Jean Tirole used the concept in his pioneering work on regulation and monopolies. The ratchet effect can denote an economic strategy arising in an environment where incentive depends on both current and past production, such as in a competitive industry employing piece rates.

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The resulting leverage dynamics can produce outcomes that cannot be explained by simple tradeoff considerations. A ratchet effect is closely related to the idea of a positive feedback loop. This constitutes a multi-period, principal-agent problem. See general information about how to correct material in RePEc. With debt in place, shareholders pervasively resist leverage reductions no matter how much such reductions may enhance firm value. In addition, like releasing a mechanical ratchet used to compress a spring, the reversal of an economic process that involves a ratchet effect may be rapid, forceful, and difficult to control. If forced to reduce leverage, shareholders are biased toward selling assets relative to potentially more efficient alternatives such as pure recapitalizations. Overview: Linear panel event studies are increasingly used to estimate and plot causal effects of changes in policies Let's look at another example. DeMarzo; Martin F.

Admati, and Peter M. DeMarzo say there is a disincentive for shareholders to urge companies to cut back on borrowing. Drew Kelly.

The ratchet effect in economics refers to escalations in production, prices, or organizational structures that tend to self-perpetuate. Mai, Nhat Chi, Peacock, A. Nyborg, Let's look at another example. Higgs, R. Extent: Online-Ressource 56 S. More details Report error. Trending Videos. Myers, Stewart C. Toni M. Full text More access options. The ratchet effect is named after the mechanical device known as a ratchet, which consists of a round gear and pivoting pawl that allows the gear to turn in one direction but not the other in order, for example, to turn a bolt or to compress a spring. Discussion Papers. If you have authored this item and are not yet registered with RePEc, we encourage you to do it here.