Short-Term Debt and Incentives for Risk-Taking

Marco Della Seta, Erwan Morellec and Francesca Zucchi
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Marco Della Seta: APG - Asset Management
Erwan Morellec: Ecole Polytechnique Fédérale de Lausanne; Swiss Finance Institute
Francesca Zucchi: Federal Reserve Board

No 19-21, Swiss Finance Institute Research Paper Series from Swiss Finance Institute

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 (search for similar items in EconPapers)
JEL-codes: G32 G35 (search for similar items in EconPapers)
Pages: 59 pages
Date: 2019-01, Revised 2019-04
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Persistent link: https://EconPapers.repec.org/RePEc:chf:rpseri:rp1921

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