Short-Term Debt and Incentives for Risk-Taking

59 Pages Posted: 9 Dec 2016 Last revised: 11 Apr 2019

See all articles by Marco Della Seta

Marco Della Seta

APG - Asset Management

Erwan Morellec

Ecole Polytechnique Fédérale de Lausanne; Swiss Finance Institute

Francesca Zucchi

Federal Reserve Board

Date Written: February 22, 2019

Abstract

We challenge the view that short-term debt curbs moral hazard and analytically demonstrate that, in a world with financing frictions and fair debt pricing, short-term debt increases incentives for risk-taking. To do so, we develop a model in which firms are financed with equity and short-term debt and cannot freely optimize their default decision because of financing frictions. Using this model, we show that short-term debt can give rise to a "rollover trap," a scenario in which firms burn revenues and cash reserves to absorb severe rollover losses. In the rollover trap, shareholders find it optimal to increase asset risk in an attempt to improve interim debt repricing and prevent inefficient liquidation. These risk-taking incentives do not arise when debt maturity is sufficiently long.

Keywords: Short-term debt financing, financing frictions, rollover risk, risk-taking

JEL Classification: G32, G35

Suggested Citation

Della Seta, Marco and Morellec, Erwan and Zucchi, Francesca, Short-Term Debt and Incentives for Risk-Taking (February 22, 2019). Swiss Finance Institute Research Paper No. 19-21. Available at SSRN: https://ssrn.com/abstract=2883220 or http://dx.doi.org/10.2139/ssrn.2883220

Marco Della Seta

APG - Asset Management ( email )

Gustav Mahlerplein 3
Amsterdam, 1082 MS
Netherlands

Erwan Morellec (Contact Author)

Ecole Polytechnique Fédérale de Lausanne ( email )

College of Management
Extranef Quartier UNIL-Dorigny
1015 Lausanne, CH-1015
Switzerland

HOME PAGE: http://sfi.epfl.ch/

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Francesca Zucchi

Federal Reserve Board ( email )

20th and C Street NW
Washington, DC 20551
United States

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