Why is Bankdebt Senior? A Theory of Priority Among Creditors

Theories of banks as efficient monitors could suggest that bank debt should be junior to other creditors in order to precipitate bankruptcy when other creditors are still in-the- money. This paper provides an explanation why bank debt is usually senior: banks would more strongly contest the priority structure in financial distress if they were junior, because they are both better organized than public debt and more appreciative of a toughness reputation in repeat relationships with other clients. This paper identifies the conditions under which firms find it efficient to award the ex-post stronger lobbyist/litigant ex-ante priority, because ``deterrence'' can reduce total creditors' expenses associated with a priority contest. For equivalent reasons, the theory can advise when public debt should be senior to trade credit and/or implicit contracts, and can even suggest one rationale for the absolute priority rule (APR). Finally, there are situations in which overall creditors' contest expenses are lower when the firm pays, thus providing a rationale for Chapter~11 creditor reimbursement procedures.