DP9930 Moral Hazard and Debt Maturity
|Author(s):||Gur Huberman, Rafael Repullo|
|Publication Date:||April 2014|
|Keyword(s):||Inefficient liquidation, Long-term debt, Optimal financial contracts, Risk-shifting, Rollover risk, Short-term debt|
|Programme Areas:||Financial Economics|
|Link to this Page:||cepr.org/active/publications/discussion_papers/dp.php?dpno=9930|
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.