Sovereign Debt and Moral Hazard: The Role of Collective Action and Contractual Uncertainty

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The ambiguous phrasing of pari passu (equal treatment) clauses in sovereign debt contracts has long baffled commentators. We show that in the presence of asymmetric information about a sovereign borrower’s ability to pay, an uncertain clause gives rise to a collective-action problem among creditors that can reduce the sovereign’s moral hazard. By varying the clause, parties can calibrate a sovereign’s expected default costs and payments to creditors and thereby optimally trade off the sovereign’s moral hazard and (deadweight) default costs. As information asymmetry decreases, a pari passu clause becomes a coarser instrument for configuring creditors’ incentives and mitigating moral hazard.

So that the door might not be shut in the face of borrowers. (Babylonian Talmud)

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