Discussion Paper Details

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Title: Moral Hazard and Debt Maturity

Author(s): Gur Huberman and Rafael Repullo

Publication Date: April 2014

Keyword(s): Inefficient liquidation, Long-term debt, Optimal financial contracts, Risk-shifting, Rollover risk and Short-term debt

Programme Area(s): Financial Economics

Abstract: We present a model of the maturity of a bank's uninsured debt. The bank borrows funds and chooses afterwards the riskiness of its assets. This moral hazard problem leads to an excessive level of risk. Short-term debt may have a disciplining effect on the bank's risk-shifting incentives, but it may lead to inefficient liquidation. We characterize the conditions under which short-term and long-term debt are feasible, and show circumstances under which only short-term debt is feasible and under which short-term debt dominates long-term debt when both are feasible. Thus, short-term debt may have the salutary effect of mitigating the moral hazard problem and inducing lower risk-taking. The results are consistent with key features of the common narrative of the period preceding the 2007-2009 financial crisis.

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Bibliographic Reference

Huberman, G and Repullo, R. 2014. 'Moral Hazard and Debt Maturity'. London, Centre for Economic Policy Research.