The leverage ratchet effect

This paper explores the implications of a “leverage ratchet effect ” whereby conflicts of interest with creditors lead shareholders to resist all forms of leverage reduction even when reducing leverage would increase firm value while generally favoring an increase in leverage even if it destroys firm value. The leverage ratchet effect is present under perfect market conditions, but is exacerbated by standard frictions. Unlike theories based on asymmetric information, the leverage ratchet effect explains shareholders ' resistance to earning retentions and rights offerings as ways to reduce leverage. In a dynamic context, the leverage ratchet effect creates an additional agency cost of debt, in that prior leverage decision will distort future leverage choices. Because leverage is effectively irreversible, firms may limit leverage initially but then “ratchet up ” in response to shocks. We show that even in a simple tradeoff model, the resulting leverage dynamics are complex and likely to produce cross-sectional distributions and comparative statics that are at odds with conventional wisdom. Finally, we consider the impact of covenants or regulation designed to limit leverage via a leverage ratio. When forced to reduce leverage, by creditors or by regulation, firms can buy back debt using proceeds obtained either by selling assets or from issuing new equity. It can also purchase ne