Insiders and Outsiders: The Choice between Informed and Arm’s‐Length Debt

Insiders and Outsiders: The Choice between Informed and Arm’s‐Length Debt

  • RAGHURAM G. RAJAN

Article first published online: 30th April 2012 DOI: 10.1111/j.1540-6261.1992.tb04662.x

Abstract


While the benefits of bank financing are relatively well understood, the costs are not. This paper argues that while informed banks make flexible financial decisions which prevent a firm's projects from going awry, the cost of this credit is that banks have bargaining power over the firm's profits, once projects have begun. The firm's portfolio choice of borrowing source and the choice of priority for its debt claims attempt to optimally circumscribe the powers of banks.

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