Seniority, Bailouts and Effect of International Lender of the Last Resort

Abstract

This paper explores the welfare effects of the seniority requirement of the ILLR, a common arrangement in the recent sovereign debt crisis in Europe that gives the ILLR seniority over existing creditors. An ILLR with seniority might decrease the interest burden of the country because it has a higher chance of getting repaid and is willing to accept a lower the interest rate. On the other hand, when an ILLR with seniority is introduced, existing creditors who would otherwise want to refrain from early liquidation, may decide to liquidate before the maturity date because the ILLR makes their claim junior. I construct a model with information asymmetries and incomplete contracts to examine the trade off between higher early liquidation by the investors and lower interest rates. The results show that ILLR intervention with seniority does not improve or even reduce the welfare of the country subject to bailout and the same welfare levels can be achieved by an ILLR without seniority. Besides, if seniority requirement is compulsory, the ILLR should keep the interest rates low enough in order not to trigger additional early liquidation. When it is possible for the country to adopt a costly policy to boost future return, then ILLR intervention with seniority can provide incentive for adoption.