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Working Paper

A Note on Absolute Priority Rule Violations, Credit Rationing, and Efficiency

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Violations of the absolute priority rule (APR) are commonplace in private workouts, formal business reorganizations, and personal bankruptcies. While some theorists suggest that these might arise endogenously, they are clearly magnified by the institutional structure of the bankruptcy code. This paper shows that APR violations exacerbate credit rationing problems by reducing the payment lenders receive in default states. Furthermore, APR violations make default more likely, raising the interest rate that firms must pay when borrowing. Both of these problems arise even when APR violations have no impact on the borrower’s incentive to undertake risk-shifting behavior.
11.01.1995ISSN 2573-7953 WP 95-13DOI 10.26509/frbc-wp-199513

Working Papers of the Federal Reserve Bank of Cleveland are preliminary materials circulated to stimulate discussion and critical comment on research in progress. They may not have been subject to the formal editorial review accorded official Federal Reserve Bank of Cleveland publications. The views expressed in this paper are those of the authors and do not represent the views of the Federal Reserve Bank of Cleveland or the Federal Reserve System.

Suggested Citation

Longhofer, Stanley. 1995. “A Note on Absolute Priority Rule Violations, Credit Rationing, and Efficiency.” Federal Reserve Bank of Cleveland, Working Paper No. 95-13. https://doi.org/10.26509/frbc-wp-199513