The Hazards of Debt: Rollover Freezes, Incentives, and Bailouts

51 Pages Posted: 7 Feb 2010 Last revised: 28 Jun 2011

Date Written: June 23, 2010

Abstract

We investigate the trade-off between incentive provision and inefficient rollover freezes for a firm financed with staggered short-term debt. First, debt maturity that is too short-term is inefficient, even with incentive provision. The optimal maturity is an interior solution that avoids excessive rollover risk while providing sufficient incentives for the manager to avoid risk-shifting when the firm is in good health. Second, allowing the manager to risk-shift during a freeze actually increases debt values via a creditor confidence channel. Debt policy should not prevent the manager from holding what may appear to be otherwise low-mean, high-volatility strategies that have option value during a freeze. Third, a limited but not perfectly reliable form of emergency financing during a freeze - a "bailout" - may improve the terms of the trade-off and increase total ex-ante value by instilling confidence in the creditor markets. Our conclusions highlight the endogenous interaction between risk from the asset and liability sides of the balance sheet.

Keywords: Rollover risk, rollover freezes, debt runs, risk-shifting, optimal maturity, bailouts, financial firms, liquidity

JEL Classification: G2, G21, G24, G28, G3

Suggested Citation

Cheng, Ing-Haw and Milbradt, Konstantin, The Hazards of Debt: Rollover Freezes, Incentives, and Bailouts (June 23, 2010). Available at SSRN: https://ssrn.com/abstract=1548531 or http://dx.doi.org/10.2139/ssrn.1548531

Ing-Haw Cheng (Contact Author)

Dartmouth College - Tuck School of Business ( email )

Hanover, NH 03755
United States

Konstantin Milbradt

Northwestern University - Kellogg School of Management - Department of Finance ( email )

Evanston, IL 60208
United States

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