Why Corporations Get Hooked on Debt

Disputing the standard models of finance, which hold that corporations carefully reckon the trade-offs of taking on higher debt, or “leverage,” the researchers argued that banks develop an almost irresistible urge to increase borrowing once they start. Leverage begets leverage, they declared, identifying a “leverage ratchet effect” that keeps banks nudging their debt higher. The ratchet stems in part from a basic conflict of interest between shareholders and creditors, and in part from government policies that encourage debt and risk-taking. Once a company begins to take on debt, they say, the leverage becomes almost “irreversible.” Shareholders will generally oppose measures that reduce debt and support moves to increase it whenever the opportunity arises. “It’s similar to eating potato chips,’’ says Paul Pfleiderer, a professor of finance at Stanford, who coauthored the new research “You may be fine if you can commit to eating just a few chips. But if you can’t stick with that commitment, you might be better off if you hadn’t started eating them at all.”

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