Violations of the absolute priority rule (APR) are commonplace in private workouts, formal business reorganizations, and personal bankruptcies. While some theorists suggest they may 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 to occur, thereby making debt financing more costly. Together, these results support the view that APR violations create an impediment to efficient financial contracting.Journal of Economic LiteratureClassification Numbers: G33, G38, K20.

The idea that banks exist to reduce the costs of monitoring is central to modern theories of financial intermediation. The fact that banks are generally granted senior positions on their small-business loans, however, is hard to reconcile with the typical view that junior lenders have the best incentives to engage in this costly monitoring. Our paper addresses this puzzling contradiction by showing that bank seniority plays an important role in encouraging the formation of valuable bank–firm relationships. The intuition behind our model lies in the fact that once the firm's prospects have deteriorated, junior creditors have incentives much like those of the firm's shareholders. Thus, it is the most senior claimant that benefits from helping the firm improve its quality. If banks are made junior to other creditors, they benefit little from additional investment in the firm during times of poor performance and hence will have little incentive to build relationships that enable them to determine the value of such an investment. As a result, making the bank senior improves its incentives to build a relationship with the firm, thereby fulfilling an important function of intermediated debt. Journal of Economic Literature Classification Numbers: G21, G32.