Presidential Address: Collateral and Commitment

Abstract

Optimal dynamic capital structure choice is fundamentally a problem of commitment. In a standard trade-off setting with shareholder-debtholder agency conflicts, full commitment counterfactually predicts the firm would rely almost exclusively on debt financing. Conversely, absent commitment a Modigliani-Miller-like value irrelevance and policy indeterminacy result holds. Thus, the content of dynamic trade-off theory must depend on the commitment technology. In this context, collateral is valuable as a low-cost commitment device. Because ex ante optimal commitments are likely to be suboptimal ex post, observed capital structure dynamics will exhibit hysteresis and depart significantly from standard predictions.