The Case for a Market in Debt Governance

Abstract

Scholars have long lamented that the growth of modern finance has given way to a decline in debt governance. According to current theory, the expansive use of derivatives that enable lenders to trade away the default risk of their loans has made these lenders uninterested, even reckless, when it comes to exercising creditor discipline. In contrast to current theory, this Article argues that such derivatives can prove a positive and powerful influence in debt governance. Theory has overlooked those who sell credit protection to lenders and assume default risk on the borrower. These protection sellers are left holding the economic risk of a loan without any legal control rights to safeguard their exposure. This Article demonstrates that the interests of lenders and protection sellers are not necessarily adversarial, as theory conventionally assumes. Rather, each side has considerable incentive to cooperate as a way to reduce its own costs of participating in the debt market and to preserve reputational capital. Recognizing this potential for cooperation, this Article proposes a market for creditor control as a cure to the crisis in debt governance. Such a market would allow lenders and protection sellers to trade control rights in debt to ensure that they are held by those with real economic skin in the game. This market aims to offer a fix to an otherwise difficult and costly problem: the misalignment seen in modern markets between those who bear the economic risk in debt and those best able to control it.