Short-Term Debt and Incentives for Risk-Taking

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We challenge the commonly accepted view that short-term debt curbs moral hazard and show that, in a world with financing frictions, short-term debt does not decrease but instead increases incentives for risk-taking. To demonstrate this result and examine its implications for corporate policies, we formulate a dynamic model in which firms face taxation, financing frictions, and default costs. Using this model, we show that short-term debt amplifies operating shocks, increases default risk, and can give rise to a rollover trap, a scenario in which firms burn cash to cover severe rollover losses. When in the rollover trap, shareholders hold an option that is out-of-the money, which provides them with risk-shifting incentives.