Short-Term Debt and Incentives for Risk-Taking
59 Pages Posted: 9 Dec 2016 Last revised: 11 Apr 2019
Date Written: February 22, 2019
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: Suggested Citation