Debt Maturity, Risk, and Asymmetric Information

Abstract

Working Paper 2004-32 December 2004 Abstract: We test the implications of Flannery's (1986) and Diamond's (1991) models concerning the effects of risk and asymmetric information in determining debt maturity, and we examine the overall importance of informational asymmetries in debt maturity choices. We employ data from more than 6,000 commercial loans from 53 large U.S. banks. Our results for low-risk firms are consistent with the predictions of both theoretical models, but our findings for high-risk firms conflict with the predictions of Diamond's model and with much of the empirical literature. Our findings also suggest a strong quantitative role for asymmetric information in explaining debt maturity. JEL classification: G32, G38, G21. Key words: debt maturity, risk, asymmetric information, banks, credit scoring Introduction Why do firms with long-term projects often borrow on a short-term basis? One answer from the debt maturity literature emphasizes the importance of risk under conditions of asymmetric information. Flannery (1986), Diamond (1991), and others provide intuitive models that rely on the volition of low-risk and high-risk firms with long-term projects choosing different maturities to reduce their financing costs or liquidity risks. Although other theories of debt maturity focus on the roles of agency costs (e.g., Myers (1977), Barnea, Haugen, and Senbet (1980)), taxes (e.g., Brick and Ravid (1985), Lewis (1990)), and other market imperfections, we concentrate on the role of asymmetric information and how it interacts with firm risk. The importance of debt maturity has also recently been highlighted in the context of policy concerns about financial crises and credit availability (e.g., Diamond and Rajan (2001)). In this paper, we test the empirical predictions of Flannery's and Diamond's theoretical models, and further explore the role of asymmetric information in debt maturity choices. Our data set provides an advantageous laboratory for these tasks. We match the maturities, risk ratings, and other contract terms of over 6,000 individual new loans to small businesses in 1997 from the Federal Reserve's Survey of Terms of Bank Lending (STBL) with Call Report data on the 53 large U.S. banks that extend these credits. We also include data from an Atlanta Federal Reserve survey on whether and how these banks employ small business credit scoring technology (SBCS), which provides our measure of asymmetric information. Prior research supports the notion that SBCS can be used to reduce informational asymmetries (Berger, Frame, and Miller (forthcoming)). We perform two main tests based on regressions of loan maturity on the risk rating of the loan, use of the SBCS technology, and other bank characteristics and loan contract terms. In Test 1, we examine whether maturity is an upward-sloping function of the risk rating as predicted by Flannery's model versus a nonmonotonic function of the risk rating with the shortest maturities for the lowest and highest risk ratings as predicted by Diamond's model. We perform Test 1 using only observations for banks that do not use the SBCS technology, given that the models predict that the relationships between debt maturity and firm risk ratings should be strongest when informational asymmetries are greatest. In Test 2, we examine the effects of reduced informational asymmetries from SBCS on debt maturities for each different risk rating. Test 2 allows us to test the implications of the effects of asymmetric information in both models, and perhaps more important, to examine the quantitative importance of informational asymmetries in debt maturity generally. A number of empirical papers examine the relationship between risk ratings and debt maturity (Test 1), although none to our knowledge examine this relationship using only observations for which informational asymmetries are expected to be the greatest. Some empirical studies examine the effects of reduced informational asymmetries on debt maturities, but none to our knowledge examine these effects by risk ratings (Test 2). …