The Pitfalls of Pledgeable Cash Flows: Soft Budget Constraints, Zombie Lending and Under-Investment

We show that when borrowers are privately informed about their creditworthiness and lenders have a soft budget constraint, efficient investment requires a limit on the fraction of a firm’s cash flows that can be pledged to outsiders. That is, pledgeability should neither be too low nor too high. An increase in pledgeability, or, more broadly, creditor rights, can either promote re-investment in zombie firms, which increases other firms’ cost of capital, or it can lead to inefficient under- investment, depending on the composition of equilibrium credit demand. Thus, greater pledgeability can reduce net social surplus, and even trigger a Pareto loss.