In this paper we focus on conflicts of interest between senior and junior debt. When coalitions between the entrepreneur and one creditor are possible, a special kind of agency problem may arise. The entrepreneur and one creditor could cooperate and change investment policy jointly, at the cost of the remaining creditor. This may even work, if asset substitution is not efficient. In principle, there are two kinds of coalition problems. The coalition comprised of the entrepreneur and the junior creditor tends to favor risk-increasing, a coalition involving the senior creditor favors risk-decreasing.

Adopting the formal framework of Bester/Hellwig (1987), we analyze the risk-decreasing coalition problem. The entrepreneur and the senior creditor form the coalition and behave opportunistically. The junior creditor may anticipate this problem and then rations credit. If the junior creditor can seize some private wealth from the entrepreneur (external collateral), the problem is mitigated. The problem can even be mitigated if the senior creditor can pledge private assets. This weakens the incentive to form a coalition. Surprisingly, the junior creditor would accept additional external collateral in favor of the senior creditor.