Reputation, Renegotiation, and the Choice between Bank Loans and Publicly Traded Debt

We model firms' choice between bank loans and publicly traded debt, allowing for debt-renegotiation in the event of financial distress. Entrepreneurs, with private information about their probability of financial distress, borrow from banks (multi-period players) or issue bonds to implement projects. If a firm is in financial distress, lenders devote a certain amount of resources (unobservable to entrepreneurs) to evaluate whether to liquidate the firm or to renegotiate its debt. We demonstrate that banks' desire to acquire a reputation for making the quot;rightquot; renegotiation versus liquidation decision provides them an endogenous incentive to devote a larger amount of resources than bondholders toward such evaluation. In equilibrium, bank loans dominate bonds from the point of view of minimizing inefficient liquidation; however, firms with a lower probability of financial distress choose bonds over bank loans