Too Much of a Good Thing? A Theory of Short-Term Debt as a Sorting Device

Abstract

Can the liquidity risk implied by short-term debt be used to sort insolvent firms out of financial markets? This paper shows that, when asset risk is unobservable, short-term financing may be socially desirable if firms’ solvency and liquidity risk are positively correlated. Nonetheless, unregulated financial firms tend to choose inefficiently short maturity structures. This inefficiency arises for two reasons. First, low-risk firms issue short-term debt to improve their funding terms when debt is rolled over, but the resulting redistribution of rents generates no social value. Second, asymmetric information between firms and lenders further distorts firms’ incentives as it leads to an excessively large reduction of long-term interest rates when more short-term debt is issued.