We develop a model that suggests a heretofore unexplored role of credit lines: To mitigate debt dilution. The results give a new perspective on the literature on leverage ratchet effects, suggesting they can be curbed by (latent) credit lines, and on latent contracts, suggesting collusive outcomes are unlikely to arise in dynamic environments. The model explains numerous facts, including why credit lines are pervasive but rarely drawn down and why they are bundled with loans, especially for riskier borrowers. We find that the risk of credit line revocation increases borrower leverage and riskiness, suggesting that limited bank commitment can contribute to corporate distress. We find empirical support for this prediction.

A hedging contract can be terminated by a counterparty following a firm's event of default, such as a credit downgrade, covenant violation, or bankruptcy. We build the model and show that although the termination right reduces hedging costs, it is inefficient because the counterparty exercising it does not consider the externality imposed on the firm. Consequently, firms hedge less, especially when facing high bankruptcy costs, and are more likely to go into liquidation. Using detailed hedging data, we find that derivatives are terminated in approximately 60% of default cases, contributing to the understanding of low hedging during financial distress.

Standard theories of debt consider a risk-neutral manager and a single contractible performance measure (“output”). It seems that debt may no longer be optimal if the manager is risk-averse and thus dislikes being the residual claimant, or if additional performance signals are available. This paper shows that debt remains the optimal contract under additional signals – they only affect the contractual debt repayment, but not the form of the contract. While debt may remain optimal under risk aversion, this may not be the case even if risk aversion is low, and even if there is no trade-off between incentives and risk sharing.