On the Coexistence of Bank and Bond Financing

This paper studies why most bond issuing firms also obtain funding from bank loans and credit lines. An entrepreneur has access to a risky investment opportunity, which is profitable ex-ante but might become unprofitable at an intermediate stage. The entrepreneur has incentives to continue an unprofitable project, which he can do if initial public borrowing has raised enough funds to also finance the project continuation. Only the bank is permanently present in the market and can provide and cancel funding on short notice. The dependence on a bank credit line constrains the entrepreneur’s continuation decision, thereby increasing ex-ante and ex-post efficiency. Bank loans act as a complement to public debt, rather than as a substitute. A contraction in bank loan supply limits access to bond financing. I conclude that public debt markets cannot always mitigate banking crises.